On Thursday, February 26, the Ministry of Finance (MoF) submitted a draft law on the improvement of the local government finance equalization (LFE) system to the Government for consideration, fulfilling the government’s mandate to prepare relevant amendments to regulatory acts by March 1 of this year. During the drafting process, consultations were held with the Ministry of Smart Administration and Regional Development, the Latvian Association of Local and Regional Governments, the Latvian Association of Large Cities, the Association of Regional Development Centres, the Latgale Planning Region, and the "Rīga Metropole" Association of Riga and Pierīga Municipalities, evaluating the proposals provided by local governments and current financial data. The majority of local governments support the further progress of the draft law, positively evaluating the prepared changes to the LFE model. At the same time, some local governments, primarily from the Pierīga region, object to the proposed LFE changes and point to the necessity of increasing state budget funding.
“The new LFE model has been developed based on both current statistics and a multi-year analysis of trends in local government revenue and expenditure development. Our goal is to ensure a fairer, more transparent, and more predictable distribution of financial resources, allowing local governments to perform their statutory functions on an equivalent basis, regardless of their fiscal capacity and socio-economic differences,” states Minister of Finance Arvils Ašeradens.
The objective of the local government finance equalization system in Latvia, as in other European Union (EU) countries, is to provide local governments with resources to perform functions at an equivalent and comparable level. It is based on the principles of solidarity and fiscal balance. At the same time, it is essential to note that LFE is not a regional development instrument, as other mechanisms are used to promote development, including EU funds, loans, and public-private partnership projects.
The current LFE regulation was adopted in 2015, and since then, the economic and fiscal environment has changed significantly. As a result of migration, tax policy changes, and administrative-territorial reform, the revenues of Riga and the Pierīga local governments have grown faster than elsewhere in Latvia, while the structure of local government expenditures has simultaneously shifted. This has created a necessity to update the values of LFE criteria and improve the distribution mechanism to align with modern costs and functional performance needs.
The new LFE model envisages several systemic solutions. Real estate tax revenues are excluded from the LFE calculation, leaving them in full at the disposal of local governments, thereby strengthening fiscal autonomy and the link between tax payment and the development of the specific territory. A new LFE distribution algorithm has also been developed, which reduces revenue disparities between local governments and allows for the departure from the previous division into "payers" and "recipients," replacing it with a unified, systemically understandable funding distribution approach.
The model provides for the reduction of the administrative burden, including the integration of state funding for interest education and catering for students in grades 1–4 into the LFE calculation. Simultaneously, the inclusion of the student count criterion in the LFE calculation allows for the abolition of mutual settlements for educational services from Grade 1, thereby reducing the administrative burden and reporting obligations.
Analysis of international data shows that Latvian local government revenue and expenditure indicators relative to gross domestic product correspond to the EU average and exceed the indicators of Baltic states with similar functions. Consequently, the improvement of the system is primarily a structural modernization to ensure a fairer and more predictable distribution. The issue regarding the amount of additional funding for the LFE is to be considered during the state budget preparation process, evaluating the overall fiscal space and the expenditure dynamics of all levels of government.
Overall, the new LFE system provides a modern, transparent, and regionally balanced financial equalization mechanism that strengthens the fiscal responsibility of local governments, reduces the administrative burden, and ensures a stable funding environment for the performance of statutory functions throughout the territory of Latvia.
The draft law is available on the Legislative Acts Portal.