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Republic of Estonia: Selected Issues

Author(s):
International Monetary Fund. European Dept.
Published Date:
May 2018
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Wages and Inflation1

A. Introduction

1. Estonia has made remarkable progress in income convergence with Western Europe. Income per capita has risen to about 51 percent of the level of EU15 (2017), the third-highest of the New Member States (NMS), and Estonia has covered the largest distance between its initial income level and the EU15’s.

Convergence

Source: Eurostat.

2. Wages have risen commensurately. However, in recent years they have increased more rapidly than labor productivity, and faster than elsewhere in Europe. While this does not immediately threaten external stability—given the current account surplus and continued volume growth in exports—continued divergence of wage dynamics from economic fundamentals could undermine growth and income convergence in the longer run (IMF 2017a), and impact adversely competitiveness.

Productivity and Unit Labor Costs 1/

(In percent, 2017/Avg. 2004–08)

Source: Eurostat.

1/ Based on hours worked.

3. In this paper, we investigate the relation between wages and inflation. Specifically:

  • What are the drivers of wage growth and inflation? Is a wage-price spiral emerging?

  • Have the direction and magnitude of drivers been different in Estonia, and have their effects been different than elsewhere in Europe?

The rest of this paper is organized as follows: In Section B, we discuss the drivers of wage growth, and how they might differ in Estonia both in their direction and magnitude, and in their impact. We also discuss a number of idiosyncrasies that can account for some of Estonia’s wage dynamics. In Section C, we formally test the effect of wage drivers. Section D concludes.

B. Drivers of Wage Growth

4. There have been three key factors as drivers of wage growth in advanced economies after the Global Financial Crisis (GFC): IMF (2017b) identifies productivity gains, inflation expectations, and labor market slack. In many countries in Europe, all these factors have worked toward pushing wage inflation lower, but in Estonia and other Baltic economies, unemployment has fallen and the labor market has tightened appreciably, while productivity growth has slowed (Figure 1). At the same time, inflation is more volatile than in larger EU economies, which may reduce the role of inflation expectations in wage formation (Capistrán and Timmermann, 2009), implying that the low inflation rates in recent years may not have had as strong a downward drag on wage settlements as elsewhere.

Figure 1.Wages and Wage Drivers

Productivity2

5. Productivity growth in Estonia, as elsewhere, has slowed, albeit from high levels that can be explained by high investment and income convergence with Western Europe. Despite this slowdown, wage growth has recovered quickly after the GFC, and from 2013 until recently, has outpaced nominal GDP growth. This implies that the labor share of national income has been rising, and real unit labor costs as well (see IMF 2017a). Nonetheless, overall the lower growth of GDP does appear to have gone hand in hand with lower wage growth: compared to pre-GFC levels, both GDP and wages are growing at a slower pace.

Wages and GDP

Year-on-year percent change)

Source: Statistics Estonia.

Inflation and Wages, 2005–17

(Year-on-year percent change)

Source: Statistics Estonia.

Inflation

6. Inflation in Estonia is generally in line with European trends, but at higher levels (reflecting income convergence) and with higher volatility.3 With Estonia one of the smallest and most open economies in the Euro Area, this is unsurprising. Moreover, the relation between wages and inflation appears to move only slowly; there are three distinct phases over the past decade: first, pre-crisis high inflation and high wage growth; second, during the crisis a rapid adjustment with negative inflation and declining wages (in nominal terms), in line with the internal devaluation’ policies; and third, a settlement of broadly stable wage growth irrespective of declining inflation rates from 2014 on.4 The limited impact of inflation over extended periods is consistent with high inflation volatility and the limited reliability of expectations. However, this does not exclude that: (i) wages do adjust rapidly when economic developments are sufficiently stark; and (ii) price dynamics eventually do influence wages (see below).

Wages and Inflation

(Year-on-year percent change)

Source: Statistics Estonia.

7. Prior to the GFC, wages appear to have led inflation. Despite the economy’s openness and small size, in the years prior to 2008, wages accelerated first, then core inflation and HCPI, suggesting the emergence of a wage-price spiral. During the GFC, wages and inflation fell broadly simultaneously, and wage growth took some time to recover to the rate of inflation. In 2013, inflation decelerated markedly, but not wage growth, and since 2016, wage growth has accelerated again, and so have measures of core and harmonized CPI, both broadly simultaneously with wages (though some of these dynamics are due to tax increases). As wage and price dynamics accelerate, care will need to be taken to avoid the emergence of another wage-price spiral.

Labor Markets

8. The labor market in Estonia appears efficient. Not only is unemployment low, but Estonia also performs well in various other metrics of labor market efficiency (Figure 2): youth unemployment is lower than in most peers; and the economy is providing employment opportunities for the low skilled, on a par with the EU28 and much more so than in peers.5 However, foreign nationals are at significantly higher risk than in, for instance, Latvia of being unemployed, relative to natives.6 This can in part be explained by geography and language skills—many of the non-nationals in Estonia are ethnic Russians who live in the economically relatively weak north-east of the country and whose command of the Estonian language is limited. This may have implications for productivity growth: if well-educated Estonian nationals emigrate and are replaced by lower-skilled foreign workers, this may drag down productivity growth.7

Figure 2.Labor Market Performance in a European Context

Instances of Negative Wage Growth

(2000–16)

Source: Eurostat.

9. Wages are flexible. Wages in Estonia have in the past adjusted downward in nominal terms (during the ‘internal devaluation’ in 2009/10), something that has happened only rarely in Europe outside the crisis countries (e.g., in other Baltic countries). This demonstrates that the current rapid wage growth can also be reversed rapidly if need be. Also, employment protection legislation is limited, providing flexibility to the labor market as a whole (and has allowed firms to hoard labor, lowering productivity). In this regard, the exposure of Estonian firms to international markets should exert significant discipline: given the small size of the domestic market and the high trade openness (exports and imports of goods and services amount to more than 150 percent of GDP), pricing power of domestic firms is likely limited, implying that the mark-up would need to adjust if wages rise faster than productivity—which is indeed what has happened.

10. Key labor market relationships have adapted to the lower-inflation environment. The Philips curve has shifted inward (Figure 3), in line with declining inflation (see above). The Beveridge curve has remained stable, suggesting that labor market mismatches have not changed much. At the same time, the labor force composition has changed: while the working age population has declined, labor force participation has steadily risen, keeping the overall labor force broadly stable, but ageing.

Figure 3.Labor Market Efficiency

11. The decline in unemployment and other metrics suggest that the labor market is tightening. While unemployment remains slightly higher than immediately before the (GFC), output now is about 1 percent above potential, while the positive output gap was much larger during 2005–08. Other metrics of labor market slack point in the same direction: involuntary part-time work is the second-lowest in the EU, and temporary contracts the fourth-lowest (Figure 4). Also, indicators of labor shortages are edging up (Eesti Pank, 2017b).

Figure 4.Indicators of Labor Market Slack

12. Migration is likely enhancing workers’ bargaining power. Estonia’s emigration rate is relatively high, which suggests that (prospective) employees have and do seek out—usually significantly higher-paid—opportunities in Nordic countries and Western Europe, both through emigration as well as commuting to Finland.8 While immigration could make up for this loss (and net migration, even in the working age group, has turned positive since 2015), some of the foreigners who arrive in Estonia—especially recently arrived Ukrainians who account for much of the recent increase in immigration—may not be as easily employable as native Estonians, and their productivity lower.

13. Overall, several factors that have tended to slow wage dynamics in other advanced economies, appear to have operated in a contrary direction in Estonia. Notably, labor markets are tight (and workers have additional bargaining power through the possibility of emigration, which many of them use), and inflation less stable than in larger economies, making it more difficult to anchor expectations.9 Hence, the decline in inflation probably had less of an impact on wages than elsewhere.

14. However, other factors should exert a strong pull toward wage moderation. In particular, the drop-in productivity growth in Estonia has been much more pronounced than in most other European economies, which should limit the room for maneuver on the part of firms. Nonetheless, Estonia’s labor income as a proportion of national income has risen significantly since pre-GFC times, and is now one of the highest in Europe—which has, however, not led to a decline in inequality, which is relatively high compared to other European countries.

Other Drivers

15. Structural changes in the work force and working conditions also play a—albeit small—role in explaining some of the increase in wages in Estonia:

  • The gender pay gap, while still high, is narrowing gradually. Everything else equal, this would drive average wages up, e.g., if wages in the public sector, which comprises many typically female professions—such as nurses or teachers—were to be raised by the state.

  • An increasing share of women in the labor force would, given the still-existing gender pay gap, push average wages down.

  • Increasing part-time work (related to higher female labor force participation) would also lower average hourly wages, as part-time work is generally less well remunerated than full-time work (even per hour).

  • Shifts in the occupational composition of the workforce could drive up average wages, as more employees move into better-remunerated jobs and professions.

Average Hourly Pay, 2014/06

(In percent)

Sources: Eurostat and IMF staff calculations.

1/ Unweighted average.

2/ Female wages, female employment, part-time/full-time, occupations.

Overall, however, the impact of these structural shifts is small. Estonia’s average hourly pay grew by 63 percent over 2006–14, and only just under 2 percent of this can be explained by these structural shifts.10 This implies that the wage increases explained by more fundamental factors discussed above is by far more important. However, this is similar to other NMS (as well as in the EU15).

Structural Components in Hourly Wages
% change 2014/06
Pay gap1.9
Female LFP−1.1
Increasing part time−0.7
Occupation1.8
Residual60.9
Total62.9
Sources: Eurostat and IMF staff calculations.
Sources: Eurostat and IMF staff calculations.

16. There are also several idiosyncratic drivers that play a role in wage settlements in Estonia. As outlined in IMF (2017a), public sector wage and minimum wage policies also have a strong influence on overall wage developments in Estonia.

  • Public sector wages (which are negotiated by social partners) have some bearing on the average wage in the economy, directly as sectors that are dominated by government employment account for almost a quarter of employment, and indirectly as they serve as a reference point for private sector wage agreements. While public sector wages have decelerated in the first half of 2017, they have started to rise again in Q3 2017, to 7 percent (4Q/4Q), though at least part of this is due to the Estonian presidency of the EU, which has driven up public sector pay during the second half of 2017. In addition, the causality also runs from private sector to public sector remuneration, as the public sector needs to remain competitive to continue to be able to staff a high-quality civil service.

  • Minimum wages are largely determined in negotiations between social partners, but government representatives are present and minimum wage agreements are given legal force. After rising by 10 percent each year during 2013–17, the rise for 2018 is being contained at 6.4 percent. However, the link between minimum wages and overall wages appears to have weakened somewhat in recent years: despite continued high increases in the minimum wage, overall wage growth has declined, and has only recently caught up again. Moreover, from 2019, social partners have agreed on a formula which includes productivity growth to guide minimum wage negotiations, and agreement has been reached to cap the minimum wage at 40 percent of the average wage.

Wage Dynamics

(Quarter-on-quarter percent change)

Sources: Statistics Estonia and https://countryeconomy.com

C. Testing the Main Drivers

17. The factors that drives wages in the Baltics, as well as the NMS, indeed appear somewhat different from those in the EU15. We consider a cross-country panel regression covering the years 1995–2016, with a variety of country groupings to determine differences in wage formation between country groupings.11 The dependent variable is nominal hourly compensation, explanatory variables are one-year-ahead inflation (as a proxy for inflation expectations), the change in real labor productivity, and as indicators of labor market slack, the share of involuntary part-time employment in total employment, and the share of employees with temporary contracts in total employment.12

18. Our regressions suggest that (see Table 1):

  • Inflation appears to have a limited impact in the NMS, in line with findings for Estonia by the Estonian Central Bank (Eesti Pank 2017a). While for all countries and in the EU15, inflation expectations have a significant impact on wages, they do not in the NMS and the Baltics. This is in line with our argument above: higher inflation volatility would make inflation expectations less reliable, and hence reduce their usefulness as an anchor.

  • Productivity is significant in all country groupings except the groups of NMS as a whole. In particular, in the Baltics the coefficient is much higher than in the EU15 group. This result appears at odds with the notion that wage growth has outpaced productivity in Estonia, but this applies only in recent years. Over the entire period, wages and productivity have broadly moved in line.

  • Indicators of labor market slack suggest that labor market conditions play a much larger role in the NMS (including the Baltics) than in the EU15 or across all countries. This would also help explain why the slowdown in productivity growth has been outweighed by labor market considerations in the former countries (and has led to relatively low unemployment there). In this regard, the positive and significant coefficient on temporary contracts—which suggests that in times of more job insecurity wages rise—in the NMS and Baltics might reflect that in these countries, temporary contracts are less a structural feature reflecting differentiated employment protection (and indeed, in many of these countries, employment protection is both lower overall, and less differentiated between permanent and temporary contracts), but a signal of labor market tightness: employers might resort to temporarily employ workers in an upswing (and not to avoid taking on employees permanently).

  • Lastly, the insignificance of the constant in the Baltics regression suggests that wages there are likely more flexible than in the EU15, a result corroborated by the negative nominal wage growth in Estonia and other NMS, but only to a limited extent in the EU15 during the GFC.

Table 1.Wage Drivers

Dependent variable: Compensation per hour worked (in national currency; % change)

All CountryEU-15NMSBaltics
Independent variables
Inflation (HCPI one year ahead, % change)0.0207*

(0.0106)
0.0127**

(0.00521)
0.0201

(0.0243)
−0.00693

(0.0319)
Real labor productivity per hour worked (% change)0.0364***

(0.0111)
0.0191***

(0.00459)
0.0421

(0.0268)
0.126***

(0.0294)
Involuntary part-time employment (age 15–74, % of total employment)−0.578***

(0.218)
−0.586***

(0.0727)
−2.492**

(1.243)
−4.876***

(1.144)
Temporary contracts (age 15–74, % of total employment)0.0289***

(0.00659)
−0.00392

(0.00282)
0.0797***

(0.0168)
0.0621**

(0.0265)
Constant−2.383

(2.323)
4.749***

(0.874)
30.58***

(7.020)
5.682

(4.296)
Fixed effectCountryCountryCountryCountry
Observations57930720053
Number of Countries3015113
Adjusted R-squared0.39590.36390.36890.4441
Sources: Eurostat, IMF staff calculations*** p<0.01, ** p<0.05, * p<0.1Standard errors in parentheses.
Sources: Eurostat, IMF staff calculations*** p<0.01, ** p<0.05, * p<0.1Standard errors in parentheses.

D. Conclusions and Policy Options

Conclusions

19. The role inflation and inflation expectations play in Estonia (and NMS) is different from those of the EU15. The impact of inflation on wage formation is smaller than in larger and richer countries with lower inflation volatility. This has limited the downward pressure on wages during the period of very low inflation in 2014–16, leading to a significant increase in labor’s share of the national income. While there has been an episode of wage growth leading inflation before the GFC, the current simultaneous acceleration in prices and wages is not evidence of a developing wage-price spiral, as a significant share of the increase in inflation is due to exogenous factors.

20. Unemployment and other metrics of labor market slack are low. This removes a factor that has contributed to low wage growth elsewhere in Europe (though in some other countries, e.g., Germany, wage growth has been modest despite low unemployment). At the same time, labor market frictions do not appear to have increased, and labor force participation has reached levels of western peers, suggesting that the scope for further increases is becoming more limited. These developments imply that labor market developments will likely further exert upward pressure on wages.

21. The productivity slowdown after the GFC has led only to a modest adjustment in wage growth. While labor productivity has a significant influence on wages in the EU15, the link in Estonia and other NMS is weaker. To some extent, this may reflect a possibly greater degree of labor hoarding in economies that are relatively small and on a convergence path, and which tend to be more volatile in terms of output growth than their EU 15 peers. Such hoarding could explain some of the productivity slowdown in recent years and, thereby, the divergence of wages from productivity. If this is the case, then productivity can be expected to pick up and the wage-productivity gap to narrow as the economy accelerates.

22. Idiosyncratic factors also play a role, but structural shifts account for a relatively small share of recent wage increases. Public sector pay is correlated with overall pay, in part because the public sector is sizable, but also because plays some benchmarking role. The association of minimum wage increases with overall pay appears to have weakened. Lastly, structural shifts are working both to raise (a declining gender pay gap, and a shift in the occupational structure of the economy) as well as to lower wage growth (increasing female labor force participation, increasing part-time work), but the total effect appears to be small.

Policy Options

23. There are a number of policy options to bring wage growth more in line with productivity. However, none alone is likely to prove decisive; hence it is important to pursue a package of measure addressing both wages and productivity.

  • Labor supply: Strengthening labor supply could alleviate wage pressures stemming from a tight labor market, but options are limited. Existing measures could be reinforced, but are likely to hit limits: (i) further streamlining public sector employment to encourage people to seek employment in the private sector; and (ii) further raising labor force participation (though the current level, at 77 percent, is already among the highest in the EU, and part-time work is also relatively rare, including among women). Moreover, immigration policies could be relaxed further, but political constraints will likely limit this as well.

  • Wages: The authorities’ options in this area are circumscribed as well, since wages are negotiated by the social partners. The government may be able to influence wage settlements to some extent through its own remuneration policies, as well as its presence in minimum wage negotiations.

  • Productivity: Raising labor productivity growth is key for continued convergence with Western Europe, which would eventually lead to wages catching up with those in EU15 countries. To this end, private sector capital investment needs to be encouraged, and public-sector investment raised. The latter would also be a means to raise the attractiveness of private investment, as public infrastructure should enhance the productivity of private investment. In this regard, adequate wage growth could also help trigger more investment if it forces employers to enhance productivity to stay competitive and/or shift into higher value-added activities. On the other hand, wage growth cannot be too high so as to deter investment. However, at the current juncture, with the economy already operating above capacity, expansion of public investment would need to be offset by other measures. It is difficult to fine-tune the economy through public investments, which typically have long gestation and implementation periods. Therefore, fiscal demand management would need to focus on revenue and current spending measures, while investment would need to be raised.

  • Tax policies: The tax system can be used to both dampen labor cost growth by reducing social security contributions and/or income taxes, and to support investment. In this regard, the recent income tax reform which has significantly reduced the tax burden on lower incomes is a good start. However, going forward, the effective progressivity of income taxation could be enhanced further. In implementing such policies, pro-cyclicality needs to be avoided: tax relief should, to the extent possible, be timed to coincide with a slowdown.

References

Prepared by Alexander Pitt with research assistance provided by Nhu Nguyen.

For a more extensive discussion of productivity and competitiveness, see IMF (2017a).

More recently, however, core inflation in Estonia accelerated markedly, to 4.1 percent y/y in Q42017, significantly higher than in Baltic and CEE peers. In part (0.9 percent), this is due to tax increases generating a one-off effect.

‘Internal devaluation’ was the strategy adopted by the Estonian authorities during the GFC to regain competitiveness, and external and fiscal balance. At the core of the strategy was a cut in nominal wage costs, both in the public and private sector.

Across the EU, low-skilled persons face significantly higher (and rising) risk of unemployment than higher-skilled person. The relatively good integration of low-skilled workers in Estonia may be indicative of a relatively slow shift to higher value-added industries.

Foreign nationals and residents born abroad account for close to 15 percent of the working-age population and labor force. This includes ethnic Russians who came to Estonia in Soviet times.

Net migration of Estonian nationals remains negative, even though overall migration turned positive in 2016.

The ferry from Tallinn to Helsinki takes 2–2½ hours, allowing weekly commutes.

At the same time, more strongly anchored inflation expectations also help stabilize actual inflation (van der Cruijsen and Demertzis, 2010).

The data only reflects employees in industry, construction and services (excluding public administration, defense, compulsory social security), which account for about 60 percent of employed persons.

The sample in the “Baltics” groups is necessarily small, limiting the number of observations, the significance of the results, and the comparability of coefficients across country groupings. However, the grouping “New Member States” is large enough to yield more robust results, which are similar to the Baltics group alone.

We have also tested the unemployment rate, alone and with other measures of labor market slack, but this variable was—to our surprise—not significant.

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