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1. Introduction

In January 2011 several European countries, including Latvia, increased their value added tax for products and services.

The VAT base rate rose from 21% to 22% and reduced VAT rates from 10% to 12%.

Every time when Latvian ministers make some economical decisions, it leads to anger and disappointment of people. In the current economical times it is jet another pressure on the Latvia's people. With high unemployment rate in the country and other bad factors such as low wages, it seems that people in the government have no compassion at all to their people.

But what really is the reason that stands behind such unpopular decisions? Latvia has a huge debt which government was hoping to decrease by getting more income from the increase of the value added tax. The reason why Latvia did it, is its plan to introduce the Euro in 2014, but in order to be able to do it it has to meet the Maastricht's convergence criteria.

Taxes are an important part of any government income, because they form the largest revenue share of the total revenue. Although the value added tax in Latvia is only one of 11 existing taxes, it has a significant role in the government's revenue. Value added tax is a comprehensive tax and its application affects the national economy as well as the population of any country, regardless of the social status, level of education, wealth and other similar criteria.

For Latvia becoming the member of the European Union also means that, as the rest of the EU member states, it has to have the tax laws aligned. It is called tax harmonization, particularly in terms of indirect tax system, which includes the value added tax. It is necessary for providing of goods and services as well as the free movement of capital between member states, which is an essential prerequisite for fair competition in the member states.

1.1. Problem statement

In the beginning of 2011 several European countries including Latvia have increased their value added tax for products and services. Latvia wants to introduce the Euro in 2014 and in order to do that, it has to meet the convergence criteria.

With the help of VAT increase Latvia was counting to reduce government debt which it obtained during financial crisis. Was it a strategically good decision to use value added tax as a tool for rising government income? How can this growth of VAT impact Latvian economy? Is it going to help Latvia fulfill the required convergence criteria?

1.2. Delimitation

In the beginning I thought about comparing the impact on the economies of the other countries which increased value added tax in the beginning of 2011 in order to determine was it a good idea in the first place to do it based on development of their economies, but I decided to rather focus on Latvian economy.

2. Methodology

In this project I am going to investigate whether it was a good idea for Latvia to increase value added tax in order to fulfill the Maastricht's criteria based on what economy of Latvia looks like in the first months of 2011.

In the beginning, I am going to collect and assess the data as a source of information about basics of the value added tax in the European Union and Latvia. I will translate the information that was gained from the Latvian books.

I am also going to search for statistical data which will represent the changes of economical development of Latvia within the last few years and development in the first months of 2011 after increasing of value added tax.

Furthermore, based on the gathered data I am going to make external analysis (PEST) of Latvian economy focusing the most on the economical aspect.

And lastly, based on the gained results of the analysis and gathered information I will come up with the conclusion to my problem statement.

3. General characteristics of Value Added Tax

3.1. Historical origins and development of Value Added Tax

Tax can be considered to be one of the oldest public institutions; its occurrence is inextricably linked to national existence. The transition from subsistence farming to cash led to the development of tax mechanism. In the history of the civilizations there is a lot of knowledge about taxes and their collection procedures. Some of the tax structures remained unchanged even to this day. However, others were significantly changed or eliminated, taking into account the impact of social, economical and political processes. Taxes as an element of the economical culture from ancient times to the present day is common to all household types, both market and non-market holdings. Historically, the tax system creation time is related to the division of social groups and occurrence of countries (institutes of public organization). As an element of public product distribution and redistribution taxes reflect the dominant socio-economic formations. Already in the beginning of capitalist economic relations, the role of the taxes in the state income and coverage of public expenditure significantly increased.

Roots of origin of VAT, with applying of certain payments for goods during various stages of production and sales, stem from the outset of the cohabitation of people. Several studies have shown that in ancient Rome the overall turnover tax was applied on goods that were sold at markets and auctions. This system was extended to Egypt, France, Spain and other countries. And yet, the value added tax is considered to be a modern tax (modern VAT). Before its introduction, the indirect taxes were used mostly for strictly defined products (i.e. excise tax on alcohol and tobacco), and in particular trade and turnover taxes. Distortions that were caused by the indirect taxation (such as vertical integration of the industry only to reduce tax liabilities), combined with rising income requirements, provided the impetus to seek alternative less distorting taxes.

The introduction of VAT started quite slowly. Maurice Lauré, director of the French tax institution, was the first person who introduced the value added tax in France on April 10th 1954, although the basic idea of ​​the Value Added Tax occurred to a German entrepreneur Dr. Wilhelm von Siemens in 1918. It was originally aimed at large enterprises, but over time it was included in all sectors.

On the manufacturing level VAT was introduced in Côte d'Ivoire in 1960, later that year in Senegal. Meanwhile, Michigan, introduced the Single Business Tax in 1953, which is a form of value added tax that is based on net revenue.

In the late 1960s spread of Value Added Tax began to pick up speed. Brazil introduced VAT in 1967, in the same year it was introduced in Denmark and consequently it began its spread in Europe. The rate of VAT introduction was sharp until the end of the 1970s of the last century, then decreased for about a decade to take over the world with a new wave.

In the Western Europe, the introduction of VAT is closely related to the high economic integration between the European Union: VAT was particularly well-suited to avoid distortions of trade, which is why it replaced a cascade of indirect taxes. By contrast, in many countries VAT was viewed as a tax, which effectively increased the budget revenues and regulated economic policy in the right direction. Rapid adoption of VAT in transition economies caused the need to replace the traditional revenue resources (such as fees for public companies), which decreased by changing to a new market economy.

Table 1: Implementation of VAT in the EU Member States

Denmark

1967

Italy

1973

Slovakia

1993

France

1968

Austria

1973

Romania

1993

Germany

1968

Spain

1986

Poland

1993

Netherlands

1969

Portugal

1986

Bulgaria

1994

Sweden

1969

Greece

1987

Finland

1994

Luxembourg

1970

Hungary

1988

Lithuania

1994

Belgium

1971

Estonia

1992

Latvia

1995

Ireland

1972

Cyprus

1992

Malta

1995

United Kingdom

1973

Czech Republic

1993

Slovenia

1999

The main reason why the Value Added Tax was introduced in Latvia was Latvia's objective of foreign policy to join the European Union (EU), which could be carried out through harmonization of the tax system including the introduction of joint customs system and the harmonization of indirect tax system.

In Latvia VAT replaced a turnover tax. Turnover tax (the so-called tavern and hotel turnover tax) on certain types of goods in the Latvian Republic was established in 1921 during the time of the first independent state. Then the rate was determined to be 15% for first class companies and 10% for second-class companies and one-off events. In the financial terms this tax was inessential. In 1940 in the Latvian Republic a Turnover Tax was introduced, which was included in the price of the goods and the rate of which amounted to 2 - 5% of retail prices. This tax was transferred to the state budget by the production and processing enterprises. Services were not levied with this tax.

Latvian “Law on Value Added Tax” took effect upon its introducing on May 1st 1995. The law originally was based on the Sixth Council Directive (77/388/EEC) as of 17th May 1977, but a number of significant deviations from the requirements of the directive had been done and subsequently in the following years the Latvian law was progressively moving towards fulfilling the EU requirements.

3.2. Theoretical description of Value Added Tax

The term "Taxes" has its origins stretching back to the centuries old history. This concept includes not only economic, but also the philosophical content. The nature of tax and discovery of its content lies within the gradual cognition of public opinion and public development. The essence of the tax can be attributed to individual income shares and concentration of national fund - the budget. At all times a question existed - how much tax is needed? Depending on the level of economic and social development, answers to this question have varied. To this day there is no common answer to this question. However, taxes are regarded as public elements of existence.

As societies developed, the tax forms changed and gradually approached the modern taxation. Constant remained only the fundamental character- to provide socialization of individual income shares as a common public interest. Why is there such need?

The development of the World's societies does not happen in the same way. Individuals hold different positions in society, depending on several factors:

  • level of income;
  • amount of wealth;
  • level of educational;
  • a state of health;
  • rank;
  • marital status;
  • culture;
  • religion and so on.

However, all are equally affected by various factors. For example,

  • natural disasters;
  • external enemies;
  • epidemics, etc.

People should think about improving of infrastructure, reducing of unemployment, development of education system, etc which are essential tasks of present time that influence how the society will be like in the future.

Before more than 300 years, forefathers of economic thinking formulated taxes differently. Different comparisons of tax can be found:

  • sacrifice, donation;
  • insurance premiums;
  • fees for public services;
  • willingness to pay, etc.

Discussions gradually resulted in development of a specific branch of economic science - the science of taxation. The systematization of this science can be attributed to era of prosperity of classical economic theories, when theory of market relations and the role of the country were developed. Particularly big contribution was made by such scholars as A. Smith, D. Ricardo, P.A. Samuelson, J.S. Mill, A. Marshall and others.

Tax science covers two main subject areas:

  1. taxes as objectively necessary economic category - the choice of types, amount of taxes, etc;
  2. the legal relations between taxpayer and the state - rights, duties, responsibilities, etc.

Development opportunities for these two spheres are varied and endless. They continue to evolve and improve. Different measures are constantly taken for establishment of an optimal tax system. There are even debates about justice, equality, democracy, social validity and impartiality of the tax system, policy and administration.

As society evolves, the previous knowledge is denied and something new is introduces, which again is denied later and so on. It is an endless cycle. Economy is pro-cyclical which makes people return to the previous opinions and makes them look at these opinions under new light and circumstances.

In parallel the theory of the state's role in the economy is developing.

As it was already mentioned, the existence of the tax is related to the existence of the state. Any government has to find means for maintenance of public administration and the provision of its essential functions. Performance of government functions is the main justification and argument for tax existence. Tax collection is an important national activity related to the cost covering.

The main findings of the modern economic science in regard to taxes can be summarized in three postulates:

  1. the tax role is not limited only to fiscal functions;
  2. an absolute limit of the taxation is taxpayer's property (capital) increase; taxes cannot be used as a taxpayer's property confiscation or reduction of capital;
  3. taxes cannot be imposed without the consent of the taxpayer (through the power of representation).

Modern science understands the tax as mandatory, forced payment without compensation, which has no penalty or compensation nature. The tax definition in legal terms includes the main features of the tax - law imposed private and corporate payments to the budget. This definition reflects both the power to determine the amount of tax as well as duty holders and the target.

Latvian law “On Taxes and Duties” defines tax as the mandatory statutory duty to the state budget or local budgets (basic budget or special budget), which is not a payment for the purchase of certain goods or services received, which is not a penalty and late payment charges as well as not a payment for the use of the public fund. The law refers the term to the national social security contributions and customs duties imposed under European Union law.

From the point of view of economic science, tax is a tool for distribution of economic resources, division of national income and macroeconomic stabilization, which reflects the existing economic and financial relations. Tax is the funding of state operations by citizens and businesses, which is focused on social needs. This definition reflects the tax functions in a market economy.

Taxes nowadays have two main functions - fiscal and economic regulatory function. From a fiscal point of view, taxes are and in the foreseeable future will be a major source for funding of public good and public needs. From the economic regulation point of view, tax is the power to influence economic entities (private citizens and legal persons) behavior and their behavior in the conditions of a market economy. In the regional (structural) policy, taxes are used to support any of the sectors or regions. Here trying to achieve tax benefits which come in the form of grants is a common thing or affecting the structure of the holding in order to redirect resources to certain directions. Often a social function of income redistribution is attributed to the tax. Similarly, taxes can act as a safeguard of domestic market and function as export support by restricting or promoting foreign trade. Mainly this is attributed to customs duties, as well as other indirect taxes which are levied in the state budget during sales process. Important role of taxes is in investment promoting (for example, exemption from levying reinvested earnings with income tax), and hence development of economy, growth stimulation. Modern theory uses indirect tax to influence social processes, support low-income residents or certain consumers groups (i.e. children's product or medication). Taxes are used for price adjustment processes, as anti-inflation policy and in other economic processes.

Depending on the objectives, there are various tax divisions according to the tax elements or in other words tax classification. Latvian taxes are classified according to the type of deduction - direct and indirect taxes. This distinction is related to the nature of taxes, the actual activity of the payer and taxable item. Note, however, that such a distinction is conditioned because some taxes, such as natural resource tax, by some signs can be direct, but by other signs, indirect. Taxes are classically divided into the tax objects: property, income and transactions. Within one group different asset, income or transaction types may be subjected with a single (one) or a variety (by item types) taxes(see Figure 2, page 38).

Direct taxes are traditionally divided into groups -real taxes (taxes on certain tax facilities - land tax, house (building) tax, professional (office) tax, securities tax) and personal taxes (taxes from the personal facilities such as income tax, property tax, capital gains tax, windfall tax on gifts (inheritance) tax, the head tax).

Indirect taxes are the second major tax category that applies to the deals and thus is included in the deals' price (value), i.e. indirectly charged from the tax burden carriers. Indirect tax category includes the individual indirect (excise) taxes, universal indirect (turnover, value added and sales) taxes, customs duties (by their origin - import, export, transit), by objectives (fiscal, protectionism, preferential, anti-dumping), by rates (specific, value (ad valorem), combined). Indirect taxes may also include the excise goods state monopolies (alcohol monopoly, etc).

Value added tax is a part of the indirect tax system, it is included in the price of goods or services, and it is paid by the final consumer of the purchased goods or services. This tax is considered to be the universal consumption tax because it is levied on all consumption, i.e. all goods and services, except from very limited number of statutory exemptions. Value added tax is considered to be a tax which does not affect enterprise, because it is not applied in the establishment process. The indirect payment determines belonging of Value Added Tax to the group of indirect taxes, because it is actually paid for the product or service as a price increase.

Any tax can be determined by using the tax elements which by their essence are necessary and sufficient to determine the taxpayer's obligations in respect of the tax (see Figure 3, page 12). Basic tax elements are mandatory for all types of taxes and include the tax rate, tax item and tax deadlines. Taxpayer, the tax base, tax period, the calculation and payment procedures, tax reliefs act as additional elements to the tax. With keying six tax elements, which would necessarily fall within the description of the tax (Tax Law), can be highlighted.

The tax payers or taxable entity, as a tax element specifies the person that is charged with duty obligations. Usually determination of tax subject is linked to gain of goods (the beneficial owner) or a person who, under the terms of business regulations, should make tax payments. Taxpayers can be individual persons or households, as well as legal persons, or permanent establishments, or a group of legal entities (the consolidated taxable).

The tax object is the economic phenomenon, which is tax applicable (income, assets, expenditure, consumption, individual transactions). Property, as the object of taxation generally is any property which is recognized under the civil rules, besides an object of particular tax may be certain types of property (real estate), alliance of some community property type or common sum of properties owned by a person within some period or at the end of period (capital, asset amount, wealth).

Object of Value Added Tax is payer's added value, which basically is the difference between the income from the tax applicable activities and material costs associated with the performing of these activities (outsourcing and supply of goods, regardless of salary). In other words, the tax object is a person's earnings and wages (goods and services, value added).

Tax base is a quantitative characteristic of the tax object, which allows determining taxable item's quantitative indicators, for which tax rate is applied. The tax base is determined by either one of the parties of the tax relations (tax administration or tax payer), or jointly by both parties in accordance with specific tax laws and other norms. The tax base serves as a basis for determining and calculating of the tax liability. At the same time it should be noted that tax base can be adjusted because of different considerations (politics, justice, efficiency etc).

To calculate tax base we can use formula - Value Added Tax in the received invoices excluding duty of material resources in suppliers' invoices. The tax is levied on a monthly or quarterly basis.

Tax rates. Tax rate is a percentage of one's income that one must pay in taxes.The tax rates can be classified as a specific rates or value rates. Today's excise tax rate is characterized by a combined rate (combination of specific rate and value rate). Similarly, tax rates can be differentiated by the principle of determination of parts or percentages. In determining the rate as a percentage of the base value, the rates may:

  1. not change in case of increasing of tax base (basic, Ad valorem tax rate);
  2. grow in case of increasing of tax base (complex, Progressive tax rate);
  3. decrease in case of decreasing of tax base (complex, Regressive tax rate).

Tax rates may be differentiated by the taxpayer or type of transaction.

Usually there are three VAT rate groups: low rates (5-12%), used for primary commodities (goods and services with inelastic demand), standard rates (15-25%), which apply generally, and increased rates (26-30 %), which apply to “luxury” goods (goods and services with elastic demand). In case of a 0% rate tax is not applied (usually in cases with export). Such transactions (delivery of goods) are considered as taxable, but with 0% rate. However, exporters have to pay input tax.

Tax reliefs. Tax relief from the tax administration's point of view may not be, but from the taxpayer's point of view is one of the most important elements of the tax. Tax relief application on income taxes usually means 30% - 40% reduction of tax, compared to the potential tax revenue. In developed countries, following types of tax relief are applied:

  • tax exemption - exclusion from obligation to pay tax or recognition of the object as tax-free facility;
  • tax deductions - reduction of the tax base;
  • tax credit - reduction of tax liability;
  • tax deferral - change of tax payment term;
  • tax annulations - taxpayer's exemption from paying the tax debt.

Tax relief may be considered to be a deflection from the general tax regime set by the laws of the respective country, which provides reduction of tax burden or a more favorable tax treatment for certain taxpayer (or group), guided by criterion that a taxpayer (or group) corresponds to a certain feature of tax law (income level, marital status, economic activity, region, etc). The tax relief cannot be applied as a replacement instrument of social policy (benefits, goods). As specific types of tax reliefs tax holidays can be applied. It is an exemption from tax liability for a fixed period, usually in cases of foreign direct investment (in Latvia it operates in accordance with the “Law on Foreign Investment in Latvian Republic” as exemption from profit tax).

Some people with a low volume of turnover and transactions which are of the social nature or do not distort competition might be exempted from value added tax. As a result, there is no tax from the final user of the goods (or services) and the input tax cannot be claimed (input tax is included in the cost). Basically, the company's added value is removed from the tax base and the company (payer) is considered the final consumer.

Organization of tax collection (taxation). Essentially, this element is necessary for determination of tax liabilities - duration of tax payment (fulfillment of tax obligations), for periodic taxes this element also includes period of tax calculation, procedures of fulfillment of tax obligations and refund order. For particular types of taxes payments in advance may be imposed (division of the tax amount), compensations for paid excess tax, incentive for premature fulfillment of tax obligations or penalties on late tax payments.

In case of repayment, based on an application, the final consumer gets a return of value added tax. From the administration's point of view value added tax is one of the most expensive taxes, it requires a large number of operations, large performance costs and a large amount of document circulation and the needs continuous control.

One of the VAT elements can also be provisions of a “reverse” tax payment procedure (the so called VAT Reverse Charge Mechanism) when the buyer of goods and services has the responsibility for payment of the tax. For determination of the tax, directives and definitions included in the national legislation have to be taken into consideration.

Since each product's value is added at each stage of production, then the value added tax is also a multi-stage tax which is applied through the entire manufacturing and production time. From the microeconomic point of view, the added value is the wage and profit, or sales revenue minus material and external costs.

In theory, you can create three mechanisms for calculating VAT:

  • additive VAT - applicable for a certain value which is formed from wages and earnings before taxes;
  • subtraction VAT (marginal tax) - imposed on the difference between sales revenue and purchases of materials and other amounts paid to external suppliers;
  • credit invoice VAT - applicable for every transaction. Difference between received tax and paid duty (input tax) forms a tax paid into the budget or a tax drawback from the budget.

Invoice tax calculation method can be expressed by the following formula:

Estimated tax = (Tax rate * Income) - (Tax rate * Expenses)

In the European Union and Latvia for the calculation of the value added tax exactly the invoice tax mechanism is applied.

Two types of VAT can be distinguished (depending on for which added value the tax is applied):

  • destination VAT - tax depends on the place of consumption (end-use). It is uually used if the country imports are subject to VAT, but exports are not taxed.
  • origin VAT - tax depends on the origin or place of production. This applies if the export is taxed in the country of its origin, but import is not taxed.

Principle of origin is not widely used in European Union law, but in some cases it is applicable. For example, this principle is used for levying of distance sales with tax if the seller of the goods had not exceeded registration limit in that certain Member State. Whereas “destination” principle is very common in the EU countries.

3.3. The role of the Value Added Tax in the European Union and Latvia

European Union, like any country has its own budget, which includes all planned income and expenditures of the various measures that the EU carries out within one year. Legal basis for the budget is set in the 199th - 209th article in the Treaty of the European Communities, , the Treaty on European Union, as well as the October 31, 1994 EU Council decision on the European Community's “own resources” system.

Budgetary revenue and expenditures must be balanced. This means that expenditures cannot exceed revenues and the budget should not have deficit. The EU cannot take loans in order to cover the deficit. If during the fiscal year (sometimes also referred to as budget year) any unpredicted expenses occur, then they are covered by additional means or by amending the budget. The budget is calculated in the EU's currency - the Euro, but the contributions from the budget are made in the national currencies.

European Union member states have to participate in the European Community's own resources system through contributions payments which ensure the EU's total revenue budget. Member State's contributions into the European Community's own resource system are calculated based on GNP (Gross National Product), the value added tax base and customs, income from agriculture and fee which is levied on sugar. In regard to the VAT contribution to the EU budget, Council Regulation (EEC, EURATOM) No 1553/89 of May 23, 1989 on the final common arrangements for the collection of own acquired resources from value added tax had been issued.

The European Community's own resources consist of:

  • traditional own resources - customs duties, import duties on agricultural products, sugar production fee;
  • value added tax resource, which is paid as a floating rate (~ 0.3%) of the member states' estimated so called ”harmonized value added tax” base - the actual VAT income and assessment which is based on a national differences in the VAT legislation from EU directives;
  • GNI resource (Gross National Income Resource), which assists the remaining general budget funds which is paid based on each Member State's national income proportion in the EU gross national income;
  • each year EU Member States have to pay two-thirds of their own resources' contributions as UK correction This so-called “British rebate” was given to Britain in 1984, at the time when its prosperity was low, but its share of the EU's common agricultural policy expenditure (on which at that time more than half of the EU's budget expenditure was spent on) was not significant.

3.4. Advantages and disadvantages of the Value Added Tax

Actually, the advantages and disadvantages of value added tax (VAT) remains to be a rather controversial issue in the literature since it was first introduction in France in 1954.

VAT supporters would usually argue that it helps businesses to compete internationally since it does not affect export prices and encourages saving that could lead to capital formation in the long run. And they would further argue that since VAT has great potential to generate a big amount of revenue with very low rate, it could help in addressing the budget deficit. Many of them are even more optimistic and consider value added tax as a tool for reducing the amount of unregistered economy in a country.

On the other hand, opponents of value added tax think that as money making machine that could lead to increase public spending and consequently a large public sector. They argue that since VAT is a hidden tax, its rate could be raised more easily than other taxes, which would raise consumer prices immediately, and consequently there would be high inflation.

The inflationary impact of VAT would appear in the form of slow economic growth or even a recession and a lower real value of existing savings. It also a big concern that since low-income persons consume a higher proportion of their income than high-income persons, value added tax should be regarded as regressive.

Although VAT supporters suggest income-tax credit to solve this problem, it is unlikely that a poor person would be eligible to pay tax. Therefore, tax credit will not provide any relief to these poor people. Increase of VAT means increase of price of goods and services which is even bigger pressure for already struggling poor people. VAT supporters further suggest exempting certain basic needs items such as food, medical care, books, electricity, and water etc. and applying a high tax rate on luxury items such as automobiles, televisions, VCRs, jewelry etc. to improve the income distribution situation in such a way so that the value added taxation system will not only become more complex, but will also create a discriminating environment among various industries.

What is seen right now in the economy of Latvia is seemingly endless cycle of bad economic key figures. All problem lies in the government dept which Latvia obtained during the financial crisis of 2008.

Basically, right now everything is built around the government deficit, possible consequences of the implementation of different tools of decreasing the debt. And to be completely honest, there are not that many options that can reduce the debt.

In the Table below we can see that clearly income is lower than the expenditures which cause the government debt:

Table 2: Main aggregates of general government (in millions of Lats)

Year

Revenue

Expenditure

Deficit (-) or surplus (+)

Deficit (-) or surplus (+) as per cent of GDP

2008

5605.9

6287

-681

-4.2

2009

4522.9

5780.5

-1257.7

-9.6

2010

4484.3

5458.4

-974.1

-7.6

However, government cannot cut the pensions and the social benefits. These two and especially the pensions are considered the untouchable spheres. The government also has to pay the social benefits for the unemployed, because the unemployment rate in Latvia is very high.

And if there are not enough people employed it just means that there are not enough (direct) tax payers. So the only possible thing left to do is to decrease the government debt with an indirect tax (Value Added Tax).

4. Taxation policy in the European Union

4.1. Tax applying in the European Union

Tax policy in the European Union as a whole is defined by the European continent's integration processes. After the World War 2 began the process of economic and political integration of the European countries. An important step in this process was the signing of the Treaty of the European Economic Community in 1957. In 1987 the European Economic Community member states decided that before the December 31, 1992 a single European Economic Community's internal market has to be established. Further economic and political integration happened along with the Treaty's entry into force in 1993. It consolidated the European Coal and Steel Community (ECSC), European Atomic Energy Community and the European Economic Community which led to creation of the European Union (EU). Subsequent changes to the establishing of the European Community Treaty (EU Treaty) was carried out by the Treaty of Amsterdam, which entered into its force in 1999 and the Treaty of Nice, which entered into force in 2003. EU Constitutional Treaty was signed in October 2004. However, in several EU member states it was not ratified. Under the EU Treaty, the European Union's task is to create a common market as well as the economic and monetary union and, by implementing the common policies, to ensure balanced and sustainable economic growth throughout the European Union, high employment and social protection, gender equality, sustainable growth without inducing increase of inflation, high level of competitiveness, economic convergence, a high level of environmental protection, increasing living standards, economic and social cohesion among member states and solidarity among member states. To ensure the success of the internal market, EU contract sets a free movement of goods, services, capital and persons within the European Union.

The European Union is more than a confederation of countries, but it is also a federal state. In fact, it is an entity new formation which could not be included in any of the traditional legal categories. Its political system is historically unique, and it has been steadily evolving for more than fifty years.

Legislations, as well as general European Union's policies are set by a trinity of main institutions which consists of the Council (represented by the member states' national governments), the European Parliament (which is representing the population) and the European Commission (a politically independent institution that protects common European interests). Council of the European Union (which is also known as the Council of Ministers) is the EU's main decision-making authority. Each EU member state in the order of rotation leads the Council for six months. Each Council meeting is attended by one minister from each member state. Depending on the discussed issues for the meetings - are those foreign affairs, agriculture, industry, transport or environment - the ministers of the respective areas would visit those meetings. Council, together with the European Parliament, has legislative powers, which is based on the co-decision making procedure. In addition, the Council and Parliament share the responsibility for making of the EU budget. The Council also concludes international agreements which are agreed by the Commission. Under the Treaty the Council acts unanimously, by a simple majority vote or a “qualified majority” vote, depending on the subject of the discussion. An examination of important issues, such as amendment of treaties, a new common policy or a new country joining the European Union, the Council has to decide unanimously. In other cases by using qualified majority. This means that the Council's decision is accepted, when the minimum of votes is gathered. Amount of every EU country's votes approximately reflects its population. To reach a qualified majority at least 255 votes out of 345 (73.9%) are needed. In addition, the decision has to be supported by the majority of the member states (in some cases, two thirds of all countries), and each member state may require proof that the total amount of ballots correspond to at least 62% of the total EU population. The European Council in principle holds meetings four times a year. It is run by the state president or prime minister, which at the moment holds the presidency of the European Union Council. President of the European Commission participates as a full member. In accordance with the Maastricht Treaty the European Council officially became the European Union's key policy initiators and it was given the power to address the issues on which ministers are unable to agree during their European Council meetings. The European Council also deals with global challenges, contributing to a common foreign and security policy (CFSP), which aims to speak with a common EU position in diplomatic matters. Decisions on tax policy at the EU level are adopted in the EU Council by consensus.

European legal system has a number of legislative acts: treaties and international agreements, directives, regulations, etc.

  1. Treaties are the primary laws of the European Union, which can be comparable to the constitutional rights at the national level. Contracts define the core elements of the Union, especially competence of those participants who the part in decision-making, legislative procedures, as well as implement the power that is allocated on them;
  2. International agreements are the second source of laws in the European Union which enables the Union to develop economic, social and political cooperation with the rest of the world. There is still a question of agreements which are closed by the international law subjects (member states or organizations) whose aim is to cooperate at the international level;
  3. Secondary legislation is the third most important source of Community law on treaties (primary legislation) and international agreements. They can be defined as a legislative package, adopted by the European institutions, under the Treaty provisions. Secondary legislation is the binding legislation (regulations, directives and decisions) and non-binding instruments (resolutions, opinions) of the Treaty, as well as a number of other documents, such as the institution's internal rules, joint action programs etc.

With regard to the application of the EU laws, it is important to note some aspects of the EU priorities - national laws remain in force, but with interpreting and applying of the law norms; ignores are those norms which are in contrary to the EU law norms. Applies are also those rules that are not directly implemented in national legislation (exception - selection rules which can be introduced by any member state). In order to understand the laws and regulations, it should be noted that EU legislation to consolidate (single-entry into the basic contract or the law, and the gradual modification or repair) is not officially in force, these texts are merely of documentary nature, and the relevant institutions are responsible for their content. On the basis of consolidated documents, the Commission may undertake a codification or transformation initiatives. Codification means the acceptance of consolidated, slightly modified text in accordance with the legislative procedure. The new text is published in the Official Journal as a legislative act and obtains an official role. For example, the Sixth VAT Directive's consolidation in December 2006. The Commission may take the initiative to transform the text, if it would considers it necessary to have any further revisions. In that case a new legislative procedure will be started.

4.2. Tax harmonization in the European Union

Tax harmonization concept was created in the process of economic integration. Before the European Economic Community (EC) was set up in 1957, the question of approximation of taxation to the legislation on the trans-national level was not important. The main focus of insurance of single European market's development means the insurance of the same international terms of trade for all housekeeping subjects. To achieve this goal the European Union (EU) the internal customs barriers are completely abolished, quantitative restrictions on imports of goods from abroad as well as limited public assistance to domestic producers is eliminated. However, for the successful implementation of common market, reduction of all barriers is required, including the tax. EU establishment Treaty Article 14 scope (in 1997 version of the Amsterdam Treaty) also spreads onto so called tax limits/ borders. Such interpretation of EC legislative framework to is done from the practical reasons. But now, many years after the signing of the Maastricht Treaty and the complete removal of customs duties, as well as non-tariff (quantitative) restrictions, the tax level and quality of the EU member has a significant impact on business activity. Essentially, without the legislative harmonization in the taxation field it is not possible to fully overcome the differences in economic conditions in different member states of the European Union.

Elimination of the provision of the internal market and threshold means in the EU cold mean realization of two objectives:

  • repeal of the tax discrimination between residents and non-member states;
  • elimination of principle disparities in tax legislation (tax law harmonization).

Tax discrimination abolition is based on two principles - the direct and indirect taxation impossibility from one EU country's side to another EU member state's products, residents, capitals with a tax size which exceeds the first country's internal taxes. The European Union member states do not have to subject other member state's residents, production, capital and services in order to indirectly protect its own residents and its market.

Tax sphere coordination's (harmonization's) basic principles are as follows:

  • regulatory coherence;
  • simultaneity of harmonized legislation accepting;
  • sequence of harmonization step;
  • international agreement's precedence over national legislation.

Tax harmonization is a systemic and by such sequential stages:

  • definition of legislation fields, which requires harmonization;
  • separation of the scope and problematic questions within the field;
  • coordination of national legislation and other laws;
  • simultaneous adoption of tax law's harmonized legislation;
  • conduction of control over harmonization decision realization.

The tax system harmonization mutual agreement process between national tax systems of different countries. This process includes tax unification, interaction, tax policy coordination

Note that the EU tax harmonization principles are based on the member states' tax sovereignty recognition, i.e. tax collection in their own territory and creating of own personal budget. Exactly on the basis of a given principle, contract, by which the EC was founded, concerns the scope of taxation only to such extent which is necessary to be able to function in the overall domestic market.

Harmonization of tax systems is only an indirect regulation of the EU primary law, which can be explained by the lack of joint strategic document which would systemize all the major provisions in the tax field. Today, the tax policy of the EU creates a separate set of decisions and the EU instruments (such as EU Council, European Parliament), which are expressed in a way of directives, regulations and decisions. At the same time, the harmonization of tax systems is subjected to the clearly defined principles. And so under the “principle of subsidiary and proportionality” the EU institutions are not entitled to independently set the tax rules without the prior approval of the EU member states.

The need for equal competitive conditions raises a number of requirements to the tax, which are becoming more and more important:

  • coordination of the national tax policy;
  • approximation of the levels of tax rates;
  • approximation of tax basis detection techniques;
  • approximation of tax reliefs.

4.2.1. Indirect tax harmonization:

Reaching of the EU's long-term development goals, including the creation of an effective common market, would not have been possible without harmonization of indirect taxing procedures in all EU member states. Indirect taxes (such as value added tax, excise and other taxes) directly affect the price formation, respectively, the trade of goods and services. At the moment European Union already has reached a high degree of harmonization of the value added tax (VAT) and other indirect taxes. Already in the first unification documents the lawmakers decided to establish a common system of VAT in all member states to make accounting and tax payment process identical for all traders and easy to use the EU budget-making.

In the 1960's two systems of the indirect taxation were applied in the European countries. France was the only state applying value added taxation system and all the other member states were applying cumulative cascade tax system of the turnover tax. Under this tax system (in contrast to value added tax) the tax was levied on the gross amount (not value added) of the production at each production stage. The cumulative cascade tax system of the turnover tax is not able to ensure the tax neutrality - the tax burden can be influenced by range of vertical or horizontal integration - it can cause distortions of the economic competition. Considering what was mentioned above, the European Commission decided, that the only system which can ensure the tax neutrality and which would not deform the market competition, is the value added taxation system.

Value added taxation system enables two possible principles of taxation:

1) the principle of destination - under this scheme the goods and services are taxed in the state of consumption. This system demands the economical cooperation because otherwise it could deform the market competition. Partly from the reason of the double taxation (in the case of goods delivered from the point of view of applying the tax by the principle of origin and by the state of delivery, the goods would be taxed for the second time according to the principle of destination) and partly from the reason of influencing competitiveness (in the situation when countries are applying different tax rates). From this reason the majority of the countries which are applying the principle of destination, exempt export from taxation and vice versa they tax import to eliminate double taxation;

2) the principle of origin - under this scheme the goods and services are taxed in the country of their production. Of course this principle is supposing the unified tax rates because the differences in tax rates can deform the market competition.

The first phase of the harmonization in the EU was dedicated to the implementing of the uniform system of indirect taxation. Without the harmonization of this system, the establishment of the internal market would not be possible, because the different indirect taxation systems could deform the market competition on the internal market.

The effort to harmonize the indirect taxes is evident from the very beginning of the economical integration process in the European Union.

Proposed harmonization had to be performed in two steps:

  1. first phase - cumulative cascade tax system of turnover tax had to be replaced by the non cumulative system;
  2. second phase - the substitution of this system by the uniform value added tax system had to follow.

All these steps were executing in relation to the establishment of the internal market, because its functioning was from the beginning the initial aim of the European Commission.

4.2.2. Legislation of the value added tax rate harmonization field:

In 1967 the first directive no. 67/227/EEC on the harmonization of legislation of the member states concerning turnover taxes was adopted. In this directive the Commission obliged all the member states to substitute existing turnover tax system by the value added taxation system on the principle of general consumption tax, which is imposed on all goods and services and which is set by the percentage of selling price and so it does not depend on the number of the stages in production or distribution process. The implementation of the value added taxation system ensured the tax neutrality. Tax rates and the tax exemptions were retained in the competency of the individual member states.

The second directive no. 67/228/EEC clearly defines the object of the taxation. The object of the taxation is the sale of goods and provision of services on the territories of the member states realized by the taxpayer, and the import of the goods. Furthermore, this directive defines the place of fulfillment, taxpayers, sale of goods and provision of services. The member states retained the right to adopt special provisions eliminating tax avoidances, further the provisions setting special program for small and medium sized companies and also this directive allows setting of special program for the agricultural sector.

The transformation of the taxation system and its implementation caused serious problems in some states. It was particularly the fact that implementation of the new system could cause the pressure on the expenditures of member states budgets. For example, Belgium collected turnover tax in the form of stamp duty and there were serious frights that transformation of the system will cause interruptions of revenue flow into the state budget.

The value added tax was proposed in Italy as a part of necessary tax reform which provoked fear from rejection from political reasons. The above mentioned was the reason for adopting of the so called “third directive” no. 69/463/EEC. The aim of this directive was to prolong the time for the implementation of the value added tax for Belgium until the end of the year 1972. The two following directives - fourth directive no. 71/401/EEC and fifth directive no.72/250/EEC were prolonging the time limit for Italy until the end of the year 1973.

The structural harmonization was finished by the implementation of the first and second directive. It was the first step towards the process of the harmonization. The result of this step was not in any case the uniform system, because directives allowed a wide range of the exemptions and differences (especially in the field of agriculture, cross - border provision of services and possibility of tax deduction from import). Instead of uniform system, there were individual systems with national differences.

The most important directive in the field of indirect tax harmonization is the sixth directive no. 77/388/EEC. It is considered to be the basic directive because it quotes the definition of the tax base, the territorial reach, the subjects, tax rates and others. The aim of this directive was to harmonize different national systems - in accordance with prerequisite comprised in the first and second directive - particularly taxation of intra - communitarian transactions. This directive is considered to be the basic and until now it has been changed for more than twenty times. From this reason the directive no. 112/2006/EC was adopted. It represents the recast of the sixth directive - e.g. it includes the sixth directive with all other directives in frame of one text.

The structural harmonization was finished by the implementation of the uniform indirect taxation system. The second step - harmonization of the tax rates, was not less complicated because of the existence of several facts:

  • tax rate harmonization is perceived by the member states as violation of their national sovereignty;
  • tax rates can serve as the tools for fiscal policy - their harmonization does not leave any space for aggregate supply and demand influencing;
  • tax rates harmonization can very seriously endanger the revenues of state budget, whereas the revenues from indirect taxation create the substantial part of budget revenues;
  • unwillingness of the European Commission to legally enforce and assure the implementation of directives in to the national tax systems;
  • national traditions - it is difficult for the states to abandon them.

During the harmonization efforts it occurred that tax rates harmonization is facing problems which are mentioned above. This is the reason why the European Commission reassessed attitude to the tax rates harmonization. Total tax harmonization which means identity of the national tax systems in all aspects to be stopped to be necessary and instead of harmonization only the approximation was considered. In scope of the approximation of tax rates there were proposed different tax bands for the value added tax.

In 1989 the European Commission firstly suggested reduced rate at 4-9% for the basic essentials of life as food, water deliveries, pharmaceutical goods, books, newspapers, magazines and public transport and standard rate at 14 - 20%.

In 1991 there was the directive no. 91/860/EEC adopted which eliminated the fiscal borders between individual member states and significantly influenced the value added taxation system applied within borders of the European Union.

The abolishment of the fiscal borders enforced following changes:

  • purchase by private entities is taxed exclusively in the state of purchase (abolishment of tax refund) with exception of purchase of the new transport means;
  • export and import system were substituted within EU by so called system of intra - communitarian acquisition of goods and services (e.g. intra - commentary fulfillment);
  • export and import system is applied only with third countries.

With effect from 1993 directive no. 92/77/EEC stipulated the minimal limit for the tax rates. For standard rate the minimum of 15% was set and for reduced rate 5%. Directive also allowed transitional period in which the member states could apply in the area of reduced tax rate (the rate lower than 5%).

Transition from the principle of destination to principle of origin belonged to the major priorities of the European Commission in the field of the indirect taxation harmonization. But the transition to the principle of origin supposes the harmonization of tax rates because in opposite case, the identical goods on the market would be sold at different prices according to the tax rates in the place of origin. From the above mentioned reasons this transition has not been done yet and principle of destination is still applied.

Although the original intention of the European Commission was only a temporary solution, the existing functioning of this system has proved to be competent. The fact that application of this principle enables member states to sustain freedom in the determination of the tax rate is ensuring the tax neutrality - member states can impose such a tax rate which does not deform the market or does not cause movement of the companies providing services to the states with lower rates.

4.2.3. Direct tax harmonization:

EU member states reached a significant progress towards harmonization of indirect taxes, while coordination of direct tax harmonization is done in concern of only certain areas, particularly in respect of corporate taxation. In regard to direct taxes, the EU Treaty does not provide specific rules. Under the subsidiary principle, the direct tax policy is left to the EU member states and it is not harmonized. However, the direct tax systems have to ensure internal market freedoms that are stated in the EU Treaty - freedom of persons, services, provision of movement of goods and capital, and insurance of the right of establishment. At the EU level only specific questions, such as cross border or double taxation, are discussed.

In the 1960's of the 20th century in the most member states of the European Union there was a similar structure of the direct taxation. All the member states excluding Italy applied the system of corporate income taxation and personal income taxation separately. The evident structural similarity of the system was hiding huge differences in the methods of tax base construction, systems of the deductible amounts and tax sales, which are significantly influencing the final tax burden of the taxpayer.

European Commission, with respect to the difference in the methods of tax base construction, during the harmonization was mainly focusing on those types of the direct taxes, where at least the partial harmonization is considered to be the necessary condition for eliminating the obstacles to the smooth functioning of internal market. Especially corporate income tax is considered to be this type of tax. The integration of the financial markets made capital a very mobile factor, which could be quickly moved to the member states with more advantageous tax regimes. In the frame of practical harmonization, the European Commission decided for the structural harmonization at first and then successively for the harmonization of the tax rates.

In the 1970's and 1980's the wide range of the harmonization efforts failed in this field, because the member state perceived them as the effort to restrict their fiscal sovereignty. The reason of the failure is also the fact that, in order for the form of directives to be obligatory for all member states, harmonization measures of the European Commission have to be introduced. The adoption of directive expects unanimity. It very often happens that the harmonization measure is blocked by one or two member states.

Growth of the globalization and the impact of the multinational corporations, some of which want to fully exploit the advantages and are connected with business activities in the internal market, resulted in the establishment of so called Ruding's committee.

The purpose of the committee was to find out:

  1. do the different systems of the corporate income taxation cause the obstacles to the internal market (especially if it acts about competition and investment);;
  2. can the obstacles be eliminated through the market forces or tax competition or there is a necessity of the intervention;
  3. which provisions will be necessary to adopt in connection with eliminating of the barriers or with their moderation.

Based on the realized research it was found out that the differences in the individual corporate tax systems are causing the obstacles on the market. Especially they influence the decisions about the investment placement of the multinational corporations.

That is the reason why the European Union has set following priorities:

  1. to eliminate provisions of the national tax systems, which cause obstacles and above all in the field of the foreign investment;
  2. to create the rules for tax base construction and to set the minimum tax rates;
  3. to ensure the transparency of all tax incentives.

It was already mentioned above that the member states are not willing to renounce their conventions and they understand the harmonization efforts as interference to the internal affairs. For that reason only the partial success was reached in this field.

5. Maastricht's convergence criteria

Maastricht convergence criteria are measures of readiness of countries for joining EMU (European monetary union) and thus readiness for the adoption of the single currency, the Euro. The criteria are defined in the Treaty on European Union of 1992 (also known as the Maastricht Treaty) which is how they got their name. They are first defined in the text of the Treaty (Article 121) and further with more precision defined in the Protocols to the Treaty. Formally there are four, but actually there are five convergence criteria, as one of them (the government budgetary position) is measured by two convergence criteria. All in all they measure nominal convergence, degree of harmonization of macroeconomic (fiscal and monetary) policies.

Countries candidates for joining EMU must meet all five Maastricht convergence criteria in order to qualify for the adoption of the Euro. Apart from nominal convergence there is also real convergence, defined as a catching-up in economic development, measured by the level of GDP per capita, or sometimes as economic reforms, institutional and structural changes needed for the catching-up process. Real convergence is not a formal prerequisite for joining the Euro area, although certain level of achieved real convergence is welcome or expected. Maastricht convergence criteria can be split into three monetary and two fiscal convergence criteria.

Maastricht convergence criteria:

  1. Inflation: Annual inflation rate should not be 1.5 percentage points higher than the average inflation rate of the three best performing EU member countries. Considering that the level of inflation in the three countries with the lowest level of inflation is changing all the time, the reference value of the Maastricht criterion on inflation also changes with time;
  2. Interest rate: The nominal long-term interest rate should not be 2 percentage points higher than the average long-term interest rates of the three EU member countries with the lowest inflation. Considering that the level of long-term interest rates in the three countries with the lowest inflation rates is changing in time, the reference value of the Maastricht criterion on interest rate also changes in time.
  3. For Latvia latest available harmonized long-term interest rate for assessing convergence (April 2011) is set at 6.47%

  4. Exchange rate: The currency of the candidate countries has to participate in the European Exchange Rate (ERM2) mechanism under the European Monetary System (EMS) for at least two years and should not have severe tensions on the foreign exchange market and devaluation of the state's currency;
  5. Government budgetary position: Government budget deficit should not exceed 3% of GDP (except in exceptional circumstances);
  6. Public debt: Public debt should not exceed 60% of GDP (or, if it is higher, it should be approaching this reference value with satisfactory speed).

“The first three convergence criteria are designed to ensure monetary stability by supporting a fixed exchange rate regime among member countries. The stability of the Euro is reinforced by the last two criteria, which protect the European Union from threats of inflation which may arise from government budget deficits.”

Table 3: Compliance with Maastricht criteria

Criteria in 2008

Latvia's achievement in 2008

Criteria in 2009

Latvia's achievement in 2009

Criteria in 2010

Latvia's achievement in 2010

Budget balance (% of GDP)

-3,0

-4,1

-3,0

-9,0*

-3,0

-7.7

Government debt (% of GDP)

60,0

19,5

60,0

36,1*

60,0

36,1

Average inflation over last 12 months (%)

4,1

15,3

1,5

3,3

1,8**

1,1

Government securities long-term interest rate (%)

6,24

6,43

5,93

12,36

5,49

12,79

Currency exchange

Fixed currency exchange against the euro and 2 years participation in ERM II

Fixed currency exchange against the euro since 2005, participation in ERM II since May, 2005

Fixed currency exchange against the euro and 2 years participation in ERM II

Fixed currency exchange against the euro since 2005, participation in ERM II since May, 2005

Fixed currency exchange against the euro and 2 years participation in ERM II

Fixed currency exchange against the euro since 2005, participation in ERM II since May, 2005

6. PEST Analysis

6.1. Political

Political Stability and Risks

In May 2004 Latvia became a Member State of the European Union. And soon after that it joined NATO.

Latvia is facing political risks. The Latvian government's approval of a new round of budget cuts for 2011, coupled with a relatively favorable progress assessment by the European Commission, suggest that the fiscal consolidation program remains on track.

As a vital requisite to keeping the joint EU-IMF lending program on track, the Latvian government on June 8, 2010 approved an additional LVL395-400mn in budget cuts for 2011 in a bid to restore public finances to a more sustainable footing. A major concession in the new budget proposal will be to ring fence wages, with Prime Minister Valdis Dombrovskis indicating that additional salary reductions are not going to be implemented. Partly that was a populist measure to shore up support among public sector workers, especially given the weak support for all the main political parties.

Government Finance

The austerity program appeared to be on track, with the European Commission indicating on June 7, 2010 that Latvia should be able to meet the 8.5% of GDP fiscal deficit target for that year. However, Latvia did even better than the expectations were from the beginning. Government deficit during 2010, even though still remaining rather big, was 7.7%.

Further fiscal consolidation might be still necessary to reduce the budget deficit to 3% in 2012 to fulfill the Maastricht convergence criterion and be able to introduce the Euro in 2014.

Public debt in 2010 was equivalent to 46.2% of GDP.

6.2. Economical

Economical situation in the country is the key factor that determines and directly affects country's chances of introducing of the Euro. It is as simple as that - country has to fulfil criteria, it has to have economical stability.

It is important to note that the government is now making a lot of steps towards getting out of the period of recession which very severely affected Latvian economy.

Overall, there are several important economical indicators which can be used to be able to determine the economical situation of the country.

GDP growth rate

The GDP (Gross Domestic Product) growth rate is the most important indicator of economic situation in the country. “A positive, rising GDP number is a sign that the economy is growing. A positive, but lower GDP value (in comparison to the previous quarter), is a sign that GDP growth is decelerating. Finally, a negative GDP value over two consecutive quarters is usually considered a recession by economists: a period of falling demand, production, and economic activity, and a source of panic and great concern for financial markets in general.”

The financial crisis affected economies of almost all countries all over the world. Many of them had low or negative GDP growth rates. Latvia was also severely affected by the crisis. The real GDP growth rate in Latvia for 2010 was -0.3%.But it is a really good indicator, because one year earlier, in 2009 the GDP growth rate was simply astonishing - 18% It was the lowest registered GDP in that year. Even though Latvia is still in the recessional period, the more optimistic figures can be seen, which indicates that the economy is recovering. In 2011 it is expected to be 3.3%.

Inflation

Inflation is another important aspect of economic activity which is directly associated with the normal growth rate and real growth rate. If inflation is high then the real growth rate of the economy will be low.

There has been a hike in inflation observed in January 2011 which was largely due to tax rises. Right now Latvia is facing a trade-off in terms of tax policy - the revenue expansion measures implemented to reduce the budget deficit have led to increased inflation. There are perhaps more to come in July. Upward price pressures come from abroad, causing increases in such first-necessity items as food, housing, and transport (e.g., electricity tariffs are planned to rise in April). Price growth for these items is increasing social problems, as inflation hits poorer households harder.

In January 2011 consumer price index (CPI) annual inflation soared to 3.7%.

The January hike in inflation was largely in line with the expectations. However, if recently announced plans to increase excise tax rates further for fuel, alcohol, and tobacco, as well as the VAT rate for natural gas as of July are approved the average inflation forecast for this year is currently set at 3%.

Unemployment

Labour market reflects the availability of particular skills at national and regional levels.

In late April 2011 the registered total unemployment rate in Latvia was 16.6%, it is still a very high unemployment in the country. As a matter of fact it is really difficult to determine whether there is a good development here because in 2010 unemployment was fluctuating a lot during the 4 quarters of the year. At this indicator has not really become that much better than it was throughout 2010.

6.3. Socio-cultural

For many centuries Latvian society has experienced cultural diversity. Different nations and cultures had left their traces and cultural heritage in Latvia. After regaining of its independence in 1990, the Republic of Latvia has resumed its way towards European values of recognizing cultural diversity within a dynamic national state and more discounting is expected as competition remains intense.

Various processes and events of recent history have had impact on ethnic structure of the society, which consists of up to 41% of representatives of more than 150 cultures of ethnic minorities. Looking through the migration indicators of 2009th proves real necessity of intercultural and socio-cultural education. The numbers show that quite a big percentage of the citizens leaving the country however rather significant number of immigrants annually comes to Latvia.

6.4. Technological and environmental

Nowadays, in the modern world with fast development of information technologies more and more people are using the internet and other modern technologies in their day-to-day life.

Latvia's communications market has evolved as more and more operators are entering the market. There is a lack of competition in the wholesale broadband access market which has been largely attributed to the lack of unbundling agreements although the situation improved a lot, with a number of unbundling agreements in place. The cable operators also offer broadband services over their networks, and Fibre-to-the-Home networks are being deployed by alternative operators. A number of wireless broadband offerings are also available. Triple play services are available from both the fixed-line and incumbent and the cable operators, which also offer digital cable TV services.

Over the years the amount of the internet users has been steadily increasing. Last year (2010) 67.8 % of the Latvian population was using internet (see Table 4, page 35).

Table 4: Internet usage in accordance to population

Year

Users

Population

% Pop.

2000

150,000

2,318,400

6.5%

2003

310,000

2,290,100

13.5%

2005

810,000

2,293,246

35.3%

2006

1,030,000

2,279,366

45.2%

2007

1,070,800

2,279,366

47.0%

2010

1,503,400

2,217,969

67.8%

7. Conclusion

During my project I came to conclusion that in the short run it might seem that value added tax increase, in order to earn more government money and decrease government debt, was not a right decision. And the statistical data of development in the first months of 2011, which I analyzed, shows rather negative impact of the VAT increase (in particular increase of the inflation rate in the first quarter of 2011), but it actually might not be a very bad decision if we look at the picture in the long run. Maybe it was not a very popular decision form the people's point of view, because it really affects the people of the lower class, but the final goal (of introducing of Euro) for Latvia is really important. It could actually have a very positive impact in the long run, because the rates are fluctuating dramatically right now, but after the introduction if the Euro Latvia will just have to keep its rates stable which will be the best possible scenario for Latvian economy.

Right now it is really difficult to predict what will happen in the future, because even when forecasts for the following years are made, they don't always turn out to be right. The financial situation is not completely clear right now either. From the key ratios (including unemployment rate, etc) the conclusion would be that Latvia is still in deep recession, however, slowly but surely the key indicators become better.

Sure, it can already be observed, that inflation rate hiked because of the VAT increase, which sure is one step back from meeting the Maastricht's criteria, but there are still a few years ahead for Latvia to stabilize this rate.

“In view of the planned euro introduction in 2014, the government is strongly committed to not raising taxes next year (except for the real estate tax), so CPI growth rates are forecast to decelerate in 2012.”

It seems that Latvia is very determined to fulfill the Convergence criteria and it seems that slowly but surely within the next few years Latvia will be able to actually fulfill these criteria.

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