Abstract
This Selected Issues paper assesses the economic recovery in Estonia that began in 1994 and accelerated in 1995, highlighting the extent to which the pattern of production has changed since the beginning of the transition in 1992, the factors that made the decline in output inevitable early on, and the sound policies that made an early recovery possible. The paper lists the policy requisites to maintain, and indeed strengthen, the growth momentum. The paper also analyzes Estonia’s experience with declining but persisting inflation since the introduction of the currency board in 1992.
III. Issues in Fiscal Policy
Estonia faces a dual set of considerations in framing and conducting fiscal policy. First, there are the financing constraints placed on the government by the currency board arrangement. Second, Estonia is an economy in transition and as such faces complex choices as it moves from a planned to a market economy. For example, difficult decisions need to be made about the pace of change in economic, social, and political affairs. In addition, transition will initiate a complex process of adaptation, creation, and destruction of organizations and institutions, and within relationships between the state and individuals. A further constraint is the past and current commitment to some “welfare state” concept. This chapter considers some of the fiscal policy issues facing Estonia, drawing some comparisons with Hong Kong, where fiscal policy has been operating under its present currency board regime since 1983, but also recognizing the problems facing transition economies. Section 1 considers the conduct of fiscal policy under a currency board. Section 2 examines the development and operation of fiscal policy in Estonia, highlighting certain weaknesses in institutional arrangements and analytical approach. Section 3 assesses fiscal developments and some emergent fiscal pressures and cites Hong Kong’s experience as indicative of what policy approach may be needed. Section 4 focuses on aspects of policy analysis in Estonia and draws attention to some weaknesses in this area. Section 5 draws some conclusions.
1. The constraint of the currency board arrangement
Operation of a currency board narrows the authorities’ monetary and fiscal policy options and reduces their opportunities to manipulate the budget irresponsibly. 1/ Recent overviews of currency board arrangements have highlighted the important condition that the monetary authorities should not lend to government as this would add the backing of domestic assets to the currency issue and rapidly undermine the viability of the currency peg. 2/ Financing must come therefore from domestic commercial banks, nonbanks, or from external sources. However, given limited domestic loanable funds for the private sector, this financing constraint encourages a government to at least maintain a balanced position on domestically financed operations. Hong Kong’s successful experience with its currency board arrangement suggests that a conservative fiscal policy is highly desirable, especially given the absence of a truly independent monetary policy and the need to contain demand pressures. Hong Kong has traditionally run a fiscal surplus and its budget has been described as “surplus-prone.” 3/ From 1991-94, Estonia managed to generate a financial surplus, but this turned to a small deficit in 1995 (Statistical Appendix Table 8). 1/ A large overall surplus in 1991 was succeeded by relatively small deficits or surpluses. Foreign financing has more than covered the overall deficit in each year and actually facilitated a build-up of domestic assets by general government.
2. The development and operation of fiscal policy in Estonia
In general, fiscal policy and the coverage of public sector activities should be framed at the most comprehensive level of general government. For Estonia, this means including (i) central government activities financed from the budget approved by Parliament; (ii) central government off-budget activities—currently confined to expenditure financed by foreign loans; (iii) the activities of the major extrabudgetary funds, i.e., the Social Insurance Fund, the Medical Insurance Fund, and the Environment Fund, whose budgets are also approved by Parliament; and (iv) local government activities, encompassing municipal expenditure financed by tax and nontax revenue, transfers from the state budget, and various forms of domestic and foreign financing. 2/
Until recently, the Estonian policy makers tended to focus on a narrower perspective, namely, the operation of the state budget, in particular the central government. 3/ Furthermore, their assessment of the impact of fiscal policy has tended to be limited by both excluding foreign-financed activities from consideration and ignoring the impulse provided by the drawdown of assets in the domestic banking system. 4/ Estonia’s existing Law on the State Budget stipulates that annual revenue and expenditure must balance, but revenue is defined to include unencumbered balances from the previous year. These practices make it more difficult for the authorities to appreciate fully the impact of fiscal operations on the economy, even just at the level of central government. Thus, while pursuing a “balanced budget” in their terms, they may unwittingly be providing a fiscal stimulus by running a conventionally defined deficit. Given the limited policy instruments available under the currency board arrangement to maintain macroeconomic stabilization and in particular price stability, it is especially important that fiscal operations in Estonia take full regard of all government activities and different forms of financing.
The conduct of fiscal policy in Estonia is further hampered by the lack of coordination between central and local government. While municipalities receive the vast majority of their revenue (about 60 percent) by getting well over half of the revenue from the national personal income tax plus sizeable transfers from the central government budget (about 25 percent of municipal revenue), they are self governments free to draw up their own budgets subject only to certain legal and administrative constraints on legitimate operations and scope of borrowing. The Government does not set targets for them either in terms of an overall fiscal objective or limits on loan financing. Similarly, oversight of their operations has not been strong. This freedom complicates fiscal policy and makes it less coherent. However, the Government will introduce measures during 1996 that will reduce the financial freedom of municipalities, in particular their ability to borrow without Parliamentary approval. Also, from January 1, 1996 the state and local budget years have coincided.
Policy formulation and execution would be somewhat easier if the Government had an analytical framework within which state and local government operations were clearly identified and integrated. Instead, fiscal policy has tended to be the aggregated outcome of disjointed decisions, whose implications in terms of macroeconomic aggregates, or their impact on specific sectors and markets, are not fully appreciated and for which corrective action may not be possible until a late stage.
This disjointedness also relates to the management of general government assets, liabilities, and liquidity. So far, government institutions tend to interact independently with domestic and international financial markets. This may make for less favorable terms for borrowing and deposits. It also loses the benefits that would accrue from a more orderly approach to financial markets in terms of reducing uncertainties about the timing and scope of movements of government resources. Coordination of central government finances has already been improved by the creation of a state Treasury, which became operational in April 1996. 1/ As the Treasury’s scope increases, further benefits may accrue from better coordination of the revenue and expenditure flows of the different general government institutions and their financing needs; the latter element has a particular bearing on municipalities. Thus, the current practice of local borrowing independent of the central authorities should continue only in the presence of strong institutional safeguards. 2/ These safeguards do not currently exist in Estonia but are in the process of being developed.
3. Managing fiscal pressures
a. The Hong Kong experience
Given Estonia’s strong desire to adhere to the principles of the currency board arrangement, Hong Kong’s long-standing experience with such an arrangement would seem to provide some useful insights. Fiscal policy in Hong Kong has been noninterventionist, aimed at maintaining a small government, fostering a competitive private sector and flexibility of wages and prices. The primary role of government has been to provide the necessary infrastructure and a stable legal and administrative framework conducive to economic growth and development. The authorities do not aim to provide some kind of welfare state and the ratio of government expenditure to GDP, at about 15 percent, is very low by international standards. The OECD average is around 40 percent and for smaller OECD countries, 50 percent (Chart 6). Efforts have been made to contain the growth of the public sector, maintain a broad balance of revenue and total expenditure, and to maintain a simple tax structure with low tax rates so as to provide maximum incentives and a stable environment for both labor and domestic and foreign investment. 1/
Hong Kong’s basic approach to taxation has been to derive revenue from a limited number of sources and to maintain low tax rates with a flat profile. Thus, income tax rates are low and almost uniform (15 percent on personal income, and 16.5 percent on corporate income). Liability to income tax is limited to Hong Kong sources only, and capital gains, dividends, and interest income 2/ are not taxed. This has resulted in a very stable structure of fiscal revenue (with taxes on earnings and profits accounting for about 46 percent of revenue during the 1990s, indirect taxes (mainly on a limited range of nonessentials) accounting for around 32 percent, and nontax revenues accounting for about 22 percent). 3/ In comparison with OECD countries, Hong Kong’s tax structure is very simple. Revenue collection has been strong, with indications of good buoyancy during the period 1980-94, 4/ one reason being strong economic growth and no prolonged recession that would put revenue under strain. In addition, the Hong Kong authorities have kept administrative and compliance costs low, and used stable tax rates to provide appropriate incentives and a stable environment for workers to work and for domestic and foreign entrepreneurs to invest.
Hong Kong’s basic approach to government expenditure has been to provide a relatively narrow range of public goods and infrastructure projects for which government supply is deemed efficient, while keeping spending increases in line with revenue growth and current spending in line with GDP growth. Spending on general administration, security, community and external affairs have been stable shares of GDP; economic services (including subsidies) have been a small and declining share of the budget as well as in relation to GDP. The buoyant tax system and rapid economic growth have meant that public spending has been financed largely by growth of the economy. However, strong control of public current expenditure has been evident during the 1990s, when there has been slower growth in compensation of employees (with wages now at 4-5 percent of GDP) and the size of the civil service has declined since 1990 (down by about 5 percent). In contrast, government investment has been the fastest growing element of GDP in the period 1990-95, wholly reflecting infrastructural development, while public residential and nonresidential building has declined. 1/
b. Fiscal revenue in Estonia
Estonia has made considerable progress in adjusting the mix of taxes towards patterns seen in market economies (Table 12). The pattern is now very close to the OECD average in terms of revenue shares, with the exceptions that social security contributions account for close to one-third of revenue in Estonia, but only about one-quarter in the OECD; and personal income tax accounts for about 20 percent of revenue in Estonia, compared to around 30 percent in the OECD. The share of revenue from personal income and profits has declined sharply from 38 percent in 1991 to 28 percent in 1995—reflecting the rapidly declining contribution of corporate income taxes—while indirect taxes have risen in importance to now account for about 32 percent of revenue.
Like Hong Kong, Estonia has a simple tax system with very few exemptions or special rules and this has created a stable environment in which economic agents can operate (Annex). The basic structure of the tax system has remained unchanged after a major reform in 1993, with flat rates for all major taxes; e.g., both personal and corporate income tax rates are 26 percent, and VAT has a single rate of 18 percent. Minor adjustments have been made to the main tax laws to reduce inconsistencies, minimize distortions, and make them more effective. Most tax rates are ad valorem, which provided some buoyancy and fiscal revenue did not suffer a prolonged collapse during the early period of transition, even though there was probably some shrinkage in the tax base. This robustness also reflects the benefits of a well-designed and quick overhaul of the tax system and a determined approach to tax administration. 2/ However, the authorities are becoming aware that maintaining tax revenue requires both improved tax design and improved tax administration, in particular, continuing to avoid exemptions and sectoral and commodity differences is essential.
OECD FISCAL INDICATORS
Citation: IMF Staff Country Reports 1996, 096; 10.5089/9781451812312.002.A003
Source: OECD Economic Outlook.Estonia: Structure of Fiscal Revenue, 1991–95
(As a percent of total revenue)
Estonia: Structure of Fiscal Revenue, 1991–95
(As a percent of total revenue)
| 1991 | 1992 | 1993 | 1994 | 1995 | |||
|---|---|---|---|---|---|---|---|
| Total revenue | 100.0 | 100.0 | 100.0 | 100.0 | 100.0 | ||
| Tax revenue | 92.8 | 92.4 | 95.0 | 94.0 | 94.9 | ||
| Direct taxes | 60.0 | 64.6 | 63.9 | 59.5 | 60.1 | ||
| Corporate profits tax | 20.5 | 16.9 | 12.0 | 8.3 | 6.4 | ||
| Personal income tax | 18.0 | 20.2 | 21.3 | 19.2 | 21.8 | ||
| Social security tax | 21.4 | 17.2 | 17.6 | 17.4 | 17.7 | ||
| Medical insurance tax | 0.0 | 10.3 | 12.6 | 13.6 | 13.4 | ||
| VAT | 16.2 | 21.2 | 23.2 | 26.5 | 24.9 | ||
| Excises | 10.9 | 4.3 | 4.7 | 4.9 | 6.9 | ||
| Taxes on international trade | 5.5 | 1.7 | 1.4 | 1.5 | 0.4 | ||
| Other taxes | 0.1 | 0.5 | 1.9 | 1.5 | 2.6 | ||
| Nontax revenue | 7.2 | 7.6 | 5.0 | 6.0 | 5.1 | ||
Estonia: Structure of Fiscal Revenue, 1991–95
(As a percent of total revenue)
| 1991 | 1992 | 1993 | 1994 | 1995 | |||
|---|---|---|---|---|---|---|---|
| Total revenue | 100.0 | 100.0 | 100.0 | 100.0 | 100.0 | ||
| Tax revenue | 92.8 | 92.4 | 95.0 | 94.0 | 94.9 | ||
| Direct taxes | 60.0 | 64.6 | 63.9 | 59.5 | 60.1 | ||
| Corporate profits tax | 20.5 | 16.9 | 12.0 | 8.3 | 6.4 | ||
| Personal income tax | 18.0 | 20.2 | 21.3 | 19.2 | 21.8 | ||
| Social security tax | 21.4 | 17.2 | 17.6 | 17.4 | 17.7 | ||
| Medical insurance tax | 0.0 | 10.3 | 12.6 | 13.6 | 13.4 | ||
| VAT | 16.2 | 21.2 | 23.2 | 26.5 | 24.9 | ||
| Excises | 10.9 | 4.3 | 4.7 | 4.9 | 6.9 | ||
| Taxes on international trade | 5.5 | 1.7 | 1.4 | 1.5 | 0.4 | ||
| Other taxes | 0.1 | 0.5 | 1.9 | 1.5 | 2.6 | ||
| Nontax revenue | 7.2 | 7.6 | 5.0 | 6.0 | 5.1 | ||
Fiscal revenue in Estonia has remained close to 40 percent of GDP throughout the 1990s—with the exception of 1992, when economic decline was at its most severe (Statistical Appendix Table 9). 1/ However, estimates indicate that, based on a wide range of determinants of tax revenue, Estonia’s fiscal revenue could be higher than predicted. 2/
Revenue from direct taxes has remained broadly stable at around 25 percent of GDP. However, this has involved a sharp decline in corporate income tax revenue, reflecting declining profitability, a higher share of wages in value added, and greater opportunities for enterprises to reduce their tax liabilities. 3/ There has been some offset from personal income tax, social security contributions, and indirect taxes. 4/ Nevertheless, direct taxes have tended to decline as a share of total revenue since 1992, in part reflecting a lowering of tax rates on income taxes at the time of the first major tax reform. Personal income and social taxes have tended to rise as a share of total revenue and now account for well over half of all revenue. These taxes have also risen in relation to GDP, from 16 percent in 1991 to about 20 percent in 1995, reflecting some increase in real wages and little increase in unemployment. 5/
Indirect taxes have gradually become more important in Estonia, accounting for about 32 percent of revenue in 1995 compared to about 27 percent in 1991. Among these taxes, VAT has become very significant, accounting for about 25 percent of revenue in 1995 (equivalent to 10 percent of GDP). Excises have also tended to increase in importance in total revenue, but are only equivalent to nearly 3 percent of GDP. 6/ The net of taxable items has been widened, but excise tax revenue has not been bolstered by the use of ad rem rather than ad valorem rates. 1/ However, improving the performance of indirect taxes may prove to be extremely difficult in the short-term unless steps are taken to curb various forms of evasion and avoidance. Recent increases in excise tax rates—e.g., on alcohol, tobacco, and gasoline—have been followed by a shrinking of the relevant tax base due to smuggling, illicit production, hoarding, and falsification of trade records. In this latter area, VAT is also vulnerable as a large part of revenue comes from imports. 2/
Although most income and assets are already subject to tax, there is still scope for broadening the tax base in Estonia. One area that is not well tapped is land and property and over time, as land privatization proceeds, one would expect to see significantly more revenue being derived from these sources, especially by municipalities. 3/
Some key elements for improved tax administration are still missing. In particular, a national audit plan is needed as is the development of basic bookkeeping standards, which would provide the right trail for uncovering fraud in VAT. Moreover, there is great scope for better coordination and information sharing between the National Tax Board and the National Customs Board. Improved tax administration needs to develop around activities rather than type of tax and taxpayer and needs to be associated with improved monitoring and follow-up, which will be facilitated by developing taxpayer identification numbers.
c. The need to re-assess public expenditure
(1) Background
By international standards, government’s role in the economy appears large in Estonia if one considers the ratio of general government expenditure to GDP (Statistical Appendix Table 10). At over 40 percent, this ratio places Estonia more in line with high income countries and well above the levels of middle income countries. Government is considerably more significant by this measure than in Hong Kong. As shown in Chart 6, however, Estonia’s Scandinavian neighbors have even larger governments. 1/ Given its income level and the level of the expenditure/GDP ratio, there would seem to be a case for Estonia to re-assess its public expenditure priorities, the effectiveness of public provision, and the relevance of continued government activity in some areas. Of course, size of government is a direct function of the responsibilities it has been assigned, which is ultimately a social and political choice. It is also related to country size, whereby bigger countries have economies of scale in the provision of administrative and security services. The inherited size of government in Estonia is large and the composition of activities may be difficult to change in the near-term.
Among transition economies, growing budget pressures have forced the need to curb cash outlays. Changes in expenditure management have been largely motivated by the need to restrain the fiscal deficit to manageable levels and cash rationing has been a key tool in this process. A common message from the recent literature is that a combination of success in pursuing economic reform and in dealing with the derived social pressures this causes raise the probability that a country will drift toward a pattern of high public spending. Estonia, motivated by the needs of the currency board arrangement, has tended to follow a disciplined fiscal approach but it too has not made fast enough reform of public expenditure and makes use of cash rationing.
Government current expenditure in Estonia is high by international standards, at close to 37 percent of GDP. Within this, the wage bill also appears high at close to 11 percent of GDP. OECD data indicate that for the wage bill 12 percent is about average for smaller and European countries, while for Finland and Sweden the ratio is closer to 15-20 percent (Chart 7). 2/ Moreover, nonwage current expenditure on goods and services has tended to increase in Estonia, and has averaged about 14 percent of GDP during the 1990s. Relative to GDP, subsidies have declined substantially since the beginning of transition and are now only 0.5 percent of GDP. Transfers to households declined sharply at the start of the transition, but have since stabilized at about 10.5 percent of GDP. However, this masks the protection provided to pensions at the expense of other benefits.
VARIOUS OECD INDICATORS
Citation: IMF Staff Country Reports 1996, 096; 10.5089/9781451812312.002.A003
Source: OECD Economic Outlook.Data for general government expenditure by function are limited to 1993 and 1994 but they indicate that in Estonia there has not been any dramatic change in the direction of public expenditure (Table 13). 1/ The proportion of spending on economic services (most of which is capital expenditure) remained broadly unchanged. A greater share has been spent on general government services, especially public order and defense (most of which is wages and salaries). These increases have been facilitated by redirecting spending away from community and social services, especially education (half of which is wages) and housing (largely capital expenditure and subsidies). Nevertheless, over two-thirds of public expenditure in Estonia is directed towards community and social services, mostly social security, welfare, education, and health.
The provision of this social infrastructure need not remain the responsibility solely of government. So far, there has been little private sector interest in providing these services, but the Government could more vigorously encourage private provision in all of these areas, limiting its own involvement to the residual areas of market failure. Estonia has already made some significant reforms in public expenditure by quickly phasing out subsidies to enterprises, which are now mainly limited to the public transport sector.
(2) Reform priorities
There are three areas of expenditure which warrant special attention because of their size and significance and the perception that there is scope in them for significant reduction: the civil service, social security, and public expenditure.
The size, employment structure, and pay levels of the civil service (covering officials in both central and local government) are problematic. The World Development Report 1996 (WDR) notes that civil servants in transition economies tend to be concentrated in the wrong areas of government, given changing functions. There is often the wrong skill mix and insufficient pay differentials and incentives are common. While government in most transition economies is not greatly overstaffed or underpaid, distribution of labor is a major problem—the core administration tends to be too small, while education, health and other public services are overstaffed. 2/ On balance, there are too few professionals and too many clerical staff. There is a shortage of skills in accounting, taxation, regulatory aspects, and public administration. Public sector pay is severely compressed and performance has little bearing on pay and promotion.
Estonia: General Government Expenditure by Function, 1993–94
(In percent of total expenditure)
Estonia: General Government Expenditure by Function, 1993–94
(In percent of total expenditure)
| 1993 | 1994 | ||
|---|---|---|---|
| General government services | 16.5 | 18.6 | |
| General pulbic services | 7.4 | 8.1 | |
| Defence affairs and services | 2.1 | 2.6 | |
| Public order and safety affairs | 7.0 | 7.9 | |
| Community and social services | 71.2 | 68.1 | |
| Education | 18.3 | 16.7 | |
| Health | 14.2 | 15.4 | |
| Social security and welfare | 27.0 | 26.7 | |
| Housing and community amenity services | 7.7 | 5.0 | |
| Recreation, culture and religious services | 3.9 | 4.2 | |
| Economic services and other unclassified services | 12.3 | 13.3 | |
| Fuel and energy affairs | 0.5 | 0.1 | |
| Agriculture, forestry, hunting and fishing | 4.1 | 3.6 | |
| Mining (excl. fuel), manufactruring and construction | 0.3 | 0.4 | |
| Transportation and communication | 6.1 | 6.6 | |
| Other economic affairs | 1.3 | 1.0 | |
| Other unclassified services | 0.0 | 1.6 | |
| Total expenditure | 100.0 | 100.0 | |
Estonia: General Government Expenditure by Function, 1993–94
(In percent of total expenditure)
| 1993 | 1994 | ||
|---|---|---|---|
| General government services | 16.5 | 18.6 | |
| General pulbic services | 7.4 | 8.1 | |
| Defence affairs and services | 2.1 | 2.6 | |
| Public order and safety affairs | 7.0 | 7.9 | |
| Community and social services | 71.2 | 68.1 | |
| Education | 18.3 | 16.7 | |
| Health | 14.2 | 15.4 | |
| Social security and welfare | 27.0 | 26.7 | |
| Housing and community amenity services | 7.7 | 5.0 | |
| Recreation, culture and religious services | 3.9 | 4.2 | |
| Economic services and other unclassified services | 12.3 | 13.3 | |
| Fuel and energy affairs | 0.5 | 0.1 | |
| Agriculture, forestry, hunting and fishing | 4.1 | 3.6 | |
| Mining (excl. fuel), manufactruring and construction | 0.3 | 0.4 | |
| Transportation and communication | 6.1 | 6.6 | |
| Other economic affairs | 1.3 | 1.0 | |
| Other unclassified services | 0.0 | 1.6 | |
| Total expenditure | 100.0 | 100.0 | |
Available statistics suggest that employment in general government in Estonia is around 130,000-140,000 (Table 14). 1/ About one-third of these workers are in the education sector; while about one-quarter are in the health sector; a further quarter are in public administration. 2/ Average employment in the sector has shown some slight increase in the period 1993-95. Estonia has about 90 general government employees per 1000 persons, which is high by OECD standards and very high compared to developing countries.3/ In Estonia, general government workers represent about 1/4 of the all wage earners—this is also high by OECD standards (about 20 percent for smaller and European countries (Chart 7)), but somewhat below the average for developing countries (about 28—for central government only). The multitude of local self governments in Estonia (254, or one municipality per 6000 persons) leads to the belief that there exists wasteful duplication within government administration.
While government employees in public administration received pay about 15 percent above the national average in 1995, those in education and health still received pay equivalent to only 80 percent of the national average, despite a notable catching up from previous years. Although the pay scale for budget sector staff in Estonia has the highest rank earning 25 times the wage of the lowest rank, this is believed to be highly compressed compared to other professional fields. Pay has often been reported as the main factor when civil servants leave government service for equivalent jobs in the private sector or in the highly lucrative financial sector. While the Government has pledged to curb the budget sector wage bill, this should not preclude better pay for civil servants, but would require more than a token decline in employment.
High spending on social security benefits, especially pensions, is a matter of great concern in the transition economies, given the feeling that the income transfer system they inherited is fiscally unsustainable. In particular, the fiscal burden is higher because of the universal eligibility of many benefits and the demographic structure of these societies. The need for a major pension reform has been under discussion for some time in Estonia and there seems to be a consensus to move from the current noncontributory, pay-as-you-go system to a contributions-based funded scheme. However, different proposals are still under consideration in Estonia, with no agreement yet on how the current rate of 20 percent paid by employers will be split when employee contributions are involved, though the Government currently favors a 10:10 split. Major problems to address in making the transition to a contributions-based system are the large number of current pensioners—about 388,000 recipients, representing 25 percent of total population and equivalent to 55 percent of the active labor force—and how to adjust for their lack of contributions. 1/
Estonia: Employment and Wages in General Government, 1993–95
(Quarterly averages)
Data are based on sample survey.
Estonia: Employment and Wages in General Government, 1993–95
(Quarterly averages)
| 1993 | 1994 | 1995 | ||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Q1 | Q2 | Q3 | Q4 | Q1 | Q2 | Q3 | Q4 | Q1 | Q2 | Q3 | Q4 | |
| (Average monthly wage; in kroons 1/ | ||||||||||||
| Public administration | 925 | 1,075 | 962 | 1,246 | 1,614 | 2,008 | 1,881 | 2,715 | 2,434 | 2,757 | 2,603 | 3,247 |
| Education | 777 | 991 | 678 | 841 | 1,042 | 1,398 | 948 | 1,641 | 1,763 | 2,028 | 1,541 | 2,383 |
| Health and social work | 684 | 872 | 824 | 997 | 1,207 | 1,496 | 1,296 | 1,614 | 1,681 | 2,055 | 1,819 | 2,366 |
| Other public sector | 729 | 913 | 815 | 905 | 1,005 | 1,261 | 1,259 | 1,677 | 1,697 | 1,926 | 1,854 | 2,100 |
| Total general government | 777 | 980 | 824 | 1,002 | 1,211 | 1,545 | 1,286 | 1,876 | 1,904 | 2,212 | 1,918 | 2,546 |
| Average wage in general government as percent of average wage for sample (in percent) | 77.6 | 83.0 | 66.9 | … | 76.0 | 80.1 | 66.6 | 81.8 | 84.9 | 86.0 | 74.1 | 88.1 |
| (Ratio of government wage to average wage) | ||||||||||||
| Public administration | 1.03 | 0.99 | 0.85 | … | 1.14 | 1.15 | 1.09 | 1.30 | 1.17 | 1.15 | 1.10 | 1.20 |
| Education | 0.87 | 0.91 | 0.60 | … | 0.74 | 0.80 | 0.55 | 0.78 | 0.85 | 0.85 | 0.65 | 0.88 |
| Health and social work | 0.76 | 0.80 | 0.73 | … | 0.86 | 0.86 | 0.75 | 0.77 | 0.81 | 0.86 | 0.77 | 0.88 |
| Other public sector | 0.81 | 0.84 | 0.72 | … | 0.71 | 0.72 | 0.73 | 0.80 | 0.81 | 0.80 | 0.78 | 0.78 |
| (Number of wage earners; in thousand persons) | ||||||||||||
| Public administration | 24.7 | 42.3 | 44.2 | 36.8 | 29.5 | 29.2 | 29.0 | 28.6 | 34.6 | 35.4 | 31.4 | 32.2 |
| Education | 42.7 | 45.0 | 40.5 | 43.9 | 47.3 | 47.0 | 50.6 | 51.3 | 44.2 | 43.3 | 45.2 | 44.6 |
| Health and social work | 30.8 | 30.3 | 31.3 | 32.0 | 32.7 | 30.7 | 32.3 | 31.4 | 33.3 | 32.1 | 32.2 | 31.0 |
| Other public sector | 17.4 | 18.2 | 19.6 | 18.8 | 18.0 | 18.2 | 18.4 | 18.5 | 22.6 | 22.2 | 20.3 | 21.7 |
| Total general government | 115.5 | 135.8 | 135.5 | 131.5 | 127.5 | 125.2 | 130.4 | 129.7 | 134.7 | 132.9 | 129.2 | 129.4 |
| Wage earners in general government as a share of all wage earners (in percent) | … | 25.3 | 25.5 | 25.7 | 25.9 | 26.4 | 27.1 | 28.1 | 25.2 | 26.7 | 26.1 | 27.3 |
Data are based on sample survey.
Estonia: Employment and Wages in General Government, 1993–95
(Quarterly averages)
| 1993 | 1994 | 1995 | ||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Q1 | Q2 | Q3 | Q4 | Q1 | Q2 | Q3 | Q4 | Q1 | Q2 | Q3 | Q4 | |
| (Average monthly wage; in kroons 1/ | ||||||||||||
| Public administration | 925 | 1,075 | 962 | 1,246 | 1,614 | 2,008 | 1,881 | 2,715 | 2,434 | 2,757 | 2,603 | 3,247 |
| Education | 777 | 991 | 678 | 841 | 1,042 | 1,398 | 948 | 1,641 | 1,763 | 2,028 | 1,541 | 2,383 |
| Health and social work | 684 | 872 | 824 | 997 | 1,207 | 1,496 | 1,296 | 1,614 | 1,681 | 2,055 | 1,819 | 2,366 |
| Other public sector | 729 | 913 | 815 | 905 | 1,005 | 1,261 | 1,259 | 1,677 | 1,697 | 1,926 | 1,854 | 2,100 |
| Total general government | 777 | 980 | 824 | 1,002 | 1,211 | 1,545 | 1,286 | 1,876 | 1,904 | 2,212 | 1,918 | 2,546 |
| Average wage in general government as percent of average wage for sample (in percent) | 77.6 | 83.0 | 66.9 | … | 76.0 | 80.1 | 66.6 | 81.8 | 84.9 | 86.0 | 74.1 | 88.1 |
| (Ratio of government wage to average wage) | ||||||||||||
| Public administration | 1.03 | 0.99 | 0.85 | … | 1.14 | 1.15 | 1.09 | 1.30 | 1.17 | 1.15 | 1.10 | 1.20 |
| Education | 0.87 | 0.91 | 0.60 | … | 0.74 | 0.80 | 0.55 | 0.78 | 0.85 | 0.85 | 0.65 | 0.88 |
| Health and social work | 0.76 | 0.80 | 0.73 | … | 0.86 | 0.86 | 0.75 | 0.77 | 0.81 | 0.86 | 0.77 | 0.88 |
| Other public sector | 0.81 | 0.84 | 0.72 | … | 0.71 | 0.72 | 0.73 | 0.80 | 0.81 | 0.80 | 0.78 | 0.78 |
| (Number of wage earners; in thousand persons) | ||||||||||||
| Public administration | 24.7 | 42.3 | 44.2 | 36.8 | 29.5 | 29.2 | 29.0 | 28.6 | 34.6 | 35.4 | 31.4 | 32.2 |
| Education | 42.7 | 45.0 | 40.5 | 43.9 | 47.3 | 47.0 | 50.6 | 51.3 | 44.2 | 43.3 | 45.2 | 44.6 |
| Health and social work | 30.8 | 30.3 | 31.3 | 32.0 | 32.7 | 30.7 | 32.3 | 31.4 | 33.3 | 32.1 | 32.2 | 31.0 |
| Other public sector | 17.4 | 18.2 | 19.6 | 18.8 | 18.0 | 18.2 | 18.4 | 18.5 | 22.6 | 22.2 | 20.3 | 21.7 |
| Total general government | 115.5 | 135.8 | 135.5 | 131.5 | 127.5 | 125.2 | 130.4 | 129.7 | 134.7 | 132.9 | 129.2 | 129.4 |
| Wage earners in general government as a share of all wage earners (in percent) | … | 25.3 | 25.5 | 25.7 | 25.9 | 26.4 | 27.1 | 28.1 | 25.2 | 26.7 | 26.1 | 27.3 |
Data are based on sample survey.
The large number of pensioners can create a vicious circle in which high pension spending requires high payroll contributions and may create incentives not to declare employment, and require yet higher contribution rates. 2/ Despite substantially higher expenditure on pensions, they have shown only a small increase relative to average wages (from 25 percent in 1993 to 28 percent in 1995) because pensioners are continuing to rise (Chart 8). Pension reform needs to address a social problem of whether the current older generation should receive special treatment. Financial savings have been destroyed by inflation and, unlike the young, the very old will not have opportunities to restore their financial situation in a market economy. Medium-term solutions require the evolution of a contributions-based benefit system, which will strengthen incentives to contribute.3/ Reform of state pensions could be accompanied by the development of a complementary system of private pensions. So far in Estonia, such schemes have been given little encouragement.
The need for, the quality, and the timing of public investment must also be reviewed. Typically, public investment in transition economies has fallen sharply, often to less than 3 percent of GDP in 1994 because wages and other current expenditure have been protected. 4/ However, in Estonia, while similarly protecting current expenditure on goods and services, public investment has been maintained at above 5 percent of GDP during 1993-95. 5/ While this level of investment was made possible initially by a good degree of public saving, this is no longer the case and foreign resources are now facilitating the maintenance of such levels of investment (see Chapter I). The common experience for transition economies is that capital repairs and renovation were given lower priority at the beginning of the transition and facilities deteriorated quickly, a process which could curb the ability of the economy to sustain a growth recovery.
In Estonia, many educational and social welfare facilities are old and in substantial disrepair and an important part of the rolling Public Investment Plan (PIP) is to renovate these, especially to improve their heat retention. 1/ Notwithstanding a sizeable amount of private investment in Estonia, in the short-term it is unrealistic to believe that the rebuilding and improvement of the national capital stock could be undertaken solely by the private sector. Public investment will remain sizeable, particularly in the short-term, and should complement private investment.2/
However, in accepting the need for continued relatively high levels of public investment, there should be a willingness to examine carefully the nature of investments and the manner in which investment decisions are made. Such decisions should be fully integrated into the budget process to ensure consistency of expenditure targets and of macroeconomic policy. A large part of the PIP involves foreign financing, and as such does not feature as part of the current budget approval process. 3/ Nevertheless, projects should be subject to both political and financial scrutiny using good appraisal methods. In framing its PIP, Estonia has begun to follow such principles. 4/
At the time of the public expenditure review the consensus developing in Estonia was that the public sector should only undertake activities where private sector success was unlikely, with a view of minimizing expenditure. The main criteria of the PIP are to undertake projects with state-wide significance and which due to their form of ownership, are subject to state financing. Therefore, projects chosen favor development of the national infrastructure (highways, ports, railroads, energy, and water purification) and completion of ongoing building. Thus, the PIP for 1996-98 is consistent with the direction of privatization by reducing involvement in production while enhancing quality of services in education, social services, public utilities and public safety. Only recently has there been greater awareness that, although large amounts of foreign financing are involved, many investment projects would appear to have a major impact in increasing demand for domestic resources and may thus tend to be more inflationary.
d. The need for a reform of local government finance
While being framed as a financial issue, the imposition of constraints on local government raises political thorns in Estonia, where municipalities enjoy wide freedom under the Constitution and the whole area of intergovernmental relations and the desirability of decentralization will not find an easy resolution. Nevertheless, changes are necessary to ensure proper control over fiscal policy. The financial aspects of intergovernmental relations have been well covered by the World Bank (1995). The report’s conclusions point towards the need for clearer practices in revenue-sharing arrangements and equalization mechanisms and highlight many issues which have quickly become critical, such as the need for control over municipal borrowing. The report also stresses that local taxes and municipalities’ own revenues are inadequate in Estonia (amounting to about 10 percent of receipts) and little more than a nuisance (in common with the experience in other transition economies).
ESTONIA WAGES AND PENSIONS
(Average per Month)
Citation: IMF Staff Country Reports 1996, 096; 10.5089/9781451812312.002.A003
1/ Bank of Estonia.2/ Statistical Office of Estonia.While recognizing the need for a major reform of local government, the Estonian authorities acknowledge that this may only occur over the medium-term. Nevertheless, the system of intergovernmental transfers can be improved by acknowledging the following general points. First, a co-operative approach can help in the equalization process. Second, the evolving role of the state may require flexibility in the size and design of transfers. Third, transfers should provide incentives for local government to raise their own revenue and manage expenditure efficiently (thus, lump sum, general purpose transfers are better than automatic gap-filling transfers). Fourth, the equalization system must meet the needs and constraints of the country.
4. The institutions of fiscal policy
Estonia cannot operate a sound economic policy without a framework for assessing fiscal and broader macroeconomic developments and without proper information for making decisions. In the near-term the analytical framework may be developed by using existing expertise within the Ministry of Finance (in close collaboration with the Bank of Estonia) to develop analysis and prepare short- and medium-term macroeconomic projections. The Ministry currently focuses on one-year forecasts to make revenue estimates for the preparation of the budget and these are prepared in the first quarter of the previous financial year. The revenue estimates involve both trend extrapolation and a forecast of GDP and its components for the next year which is used as an explanatory factor for the revenue estimates. Despite these exercises, there is little policy orientation in the work of the Ministry’s Economic Policy Department and policy decisions are not always taken on the basis of thorough and systematic analysis of the possible results, for example, of tax changes. Development of capabilities in both these areas is essential. There is a need to incorporate budget estimates into a comprehensive medium-term macroeconomic strategy and budget preparation should be used as a time of intensive discussion of strategic macroeconomic and related sectoral problems (e.g., on the basis of a medium-term economic and fiscal policy paper to be discussed in Cabinet) and to achieve a Government consensus on the strategy to be followed.
With a change of analytical perspective, policy development would be helped by some institutional changes. Namely, Parliament and the Government need to focus on more than just the domestic operations of central government and the Ministry of Finance should have clear, formal responsibility for overseeing all financial activities of all general government units. This would be consistent with a change in analytical perspective that involved developing a set of analytical accounts for general government at the unconsolidated and consolidated levels which shows clearly the inter-relationship of government units and the overall fiscal balance. A considerable improvement in the quality of data on fiscal operations in the direction of meeting the needs of economic analysis would be a prerequisite.
5. Conclusions
In attempting to sustain their fiscal adjustment effort, the Estonian authorities should recognize that there is no sign that the system is prone to overall surpluses—as in Hong Kong—and efforts are therefore needed to achieve at least a balanced overall fiscal position or contain the size of the overall deficit. Estimates suggest that Estonia’s fiscal revenue could be higher than predicted, and its expenditure lower; this suggests that the fiscal account has considerably more potential to be in deficit. Public saving has tended to decline recently and the authorities may be more inclined to make use of foreign financing to bolster expenditure rather than implement radical expenditure reform. This could undermine stabilization and hinder private sector growth.
Estonia’s significant economic progress needs to be set in the context of the experience of successful transition economies, where fiscal reform has been speedy on the revenue side, but expenditure reform has been relatively slow. In common with those countries, expenditure reform has focused on reducing subsidies. Despite the disciplined approach to fiscal policy which Estonia has tried to follow, wider ranging expenditure reform seems appropriate. As indicated in Chapter I, while there is no clear conclusion about government spending hindering economic growth, inefficient public expenditure would impose some kind of brake. Furthermore, the high degree of revenue mobilization required to sustain the present level of expenditure may in time be stifling enterprises and distorting labor market decisions. In this regard, payroll taxes equivalent to 33 percent of wages are likely to become a burden once the on-going realignment of prices in Estonia is completed (Chapter II).
Recognition should also be given to the potential for weaker revenue performance and questions raised about the sustainability of the revenue effort in Estonia. In the near- and medium-term more emphasis should be placed on developing the effectiveness of tax administration (without moving away from the current admirably simple system). At least, the persistence of high degrees of evasion and avoidance must be addressed.
Finally, major institutional changes are also needed, e.g., in the budget law; in the process of budget preparation; in the integration of the accounts of general government units; in fiscal analysis; and in resource allocation procedures. The early development of an analytical framework will help in better assessing the nature and impact of fiscal activity and its relation to macro-economic policy.
References
Barbone, Luca, and Hanna Polackova, 1996, “Public Finances and Economic Transition,” Policy Research Working Paper 1585. (Washington: World Bank).
Bennett, Adam G.G., 1992, “The Operation of the Estonian Currency Board,” IMF Paper on Policy Analysis and Assessment 92/3 (Washington: International Monetary Fund).
Bennett, Adam G.G., 1994, “Currency Boards: Issues and Experiences,” IMF Paper on Policy Analysis and Assessment 94/18 (Washington: International Monetary Fund).
Borensztein, Eduardo, and Peter J. Montiel, 1992, “Savings, Investment, and Growth in Eastern Europe,” Central and Eastern Europe Roads to Growth, ed. by Georg Winckler (International Monetary Fund-Austrian National Bank).
Gupta, Sanjeev, Gerd Schwartz, and Caroline Van Rijckeghem, 1995, “The Kyrgyz Republic: Policy Options in Public Expenditure,” Fiscal Affairs Department (Washington: International Monetary Fund).
Hemming, Richard, 1995, “The Revenue Decline,” Policy Experiences and Issues in the Baltics. Russia, and Other Countries of the Former Soviet Union, ed. by Daniel A. Citrin and Ashok K. Lahiri, IMF Occasional Paper No. 133 (Washington: International Monetary Fund).
International Monetary Fund, 1993, United Kingdom: Hong Kong—Recent Economic Developments. SM/93/13 (Washington).
International Monetary Fund, 1995, Guidelines for Fiscal Adjustment. IMF Pamphlet Series, No. 49 (Washington).
International Monetary Fund, 1996, United Kingdom: Hong Kong—Recent Economic Developments. SM/96/46 (Washington).
International Monetary Fund-World Bank-OECD-EBRD (JSSE), 1991, A Study of the Soviet Economy, Volume 1.
Kraay, Aart, and Caroline Van Rijckeghem, 1995, “Employment and Wages in the Public Sector—A Cross-Country Study,” IMF Working Paper No. 95/70 (Washington: International Monetary Fund).
Ministry of Finance of the Republic of Estonia, 1995, State Investment Program for the years 1996 through 1998.
Osband, Kent, and Delano Villanueva, 1992, “Independent Currency Authorities: An Analytical Primer,” IMF Working Paper No. 92/50 (Washington: International Monetary Fund).
World Bank, 1995, Report on Local Government Financing. Report No. 14925-EE (Washington).
World Bank, 1996a, Estonia; Living Standards During the Transition. Report No. 15647-EE (Washington).
World Bank, 1996b, World Development Report 1996—From Plan to Market (Washington).
Bennett (1992) and (1994). In the case of the Argentine currency board arrangement backing for base money can be in the form of dollar-denominated government debt.
The financial balance is defined as the balance of all general government operations excluding net lending operations.
It is important for analytical purposes that the 254 municipalities follow uniform practices in framing budgets and reporting data on their activities.
The state budget approved by Parliament covers only those operations of central government and the major extrabudgetary funds (Social Insurance Fund, Medical Insurance Fund, and Environment Fund) which are financed by taxes and nontax revenue.
This was the standard practice in Soviet financial accounts. See, for instance, JSSE (1991).
From July 1996, the Environment Fund will also be included; and discussions are underway to include the Social Insurance Fund and Medical Insurance Fund from January 1997.
Currently, the Law on Municipal and Town Budgets stipulates that municipalities may borrow subject to a threshold that debt service does not exceed 20 percent of projected receipts (excluding loans) in the latest budget. These limits have been either ineffective or not enforced when effective.
Except for banks and corporations operating in Hong Kong.
International Monetary Fund (1996). This flat profile means a lack of automatic stabilizers as would exist in graduated income tax systems and recent concern has focused on vulnerability to cyclical downturns.
Defined as the growth rate of revenue relative to that of nominal GDP.
International Monetary Fund (1993) and (1996). Compared with 0ECD countries, Hong Kong has a notable absence of large expenditure on defense and social security (reflecting the existence of only private pension funds). Public expenditure on education and health is much lower than in the OECD; while it is comparable in housing, security, and administration.
See Hemming 1995.
As Chart 6 shows, this is a good performance in comparison to OECD countries.
This has involved using accelerated depreciation allowances and sheltering profits by offshore registration now possible with an open economy and the development of international links.
This trend has been evident in all three Baltic republics.
Social taxes are not withheld and compliance rates vary between the two components covering social insurance (20 percent) and medical insurance (13 percent). Compliance for the latter has tended to be higher as health benefits only accrue to registered taxpayers. Thus, there are 630,000 contributors for social insurance and 799,000 health insurance contributors (World Bank 1996a). Social insurance tax compliance has tended to improve in the recent past as debate has hinted at changes to a contributions-based pens ions scheme.
Excises are levied mainly on nonessentials—alcohol, tobacco, motor vehicles, and motor fuel.
The Ministry of Finance can raise rates based on developments in the CPI, without Parliamentary approval.
Evasion is mainly in the form of undervalued imports, and overvalued or phantom exports. For both excises and VAT, phantom companies are often created to facilitate evasion.
Estonia gets less than one percent of revenue from land taxes, whereas the OECD average from land and property taxes is 5-6 percent.
Finland, with which comparisons are often made, has raised Its ratio of government expenditure to GDP from around 38 percent in the late 1970s to around 60 percent in the 1990s—from well below the OECD-Europe average to substantially above. In the process it has converged toward the levels for Sweden, a country which has been well above the OECD-Europe average during the same period. Scandinavian countries all have extensive social provisions and may be indicative of the direction to which Estonia would tend without expenditure reform.
Data availability limit international comparisons, but Kraay and Van Rijckeghem (1995) citing the Government Finance Statistics Yearbook 1994 indicate that for high and low income countries government wages/GDP were 7 percent, and for middle income countries about 8-8 1/2 percent. Comparisons, however, may be hazardous as it is not always clear if data include social security contributions, as is done in Estonia.
Unfortunately, these data are not on a comparable basis with data in this chapter for general government by economic classification.
There is little detailed information on these aspects. However, a recent study of the Kyrgyz Republic found that obsolete functions continue to be staffed, including planning activities, while ministries and departments with functions that were gaining importance were in need of staff. See Gupta et al. 1995.
Within this total, central government employs 74,000 (of which, administrative staff are 14,000 and 32-33,000 staff are in the education sector); local government employs 42-43,000; and there are 15-16,000 medical personnel.
This category includes staff in defense and social security administration.
Comparative statistics are for the period 1981–92 and tabulated in detail by Kraay and Van Rijckeghem (1995). These statistics indicate that in the OECD the average level of general government employees per 1000 was about 82, for 1981-92; while in developing countries the average (for central government) was about 23.
Some 43,000 working pensioners were added from April 1, 1996, which will further strain the current system.
The ratio of social taxes to GDP in Estonia is about equivalent to those for small and European OECD countries, though several points lower than in Finland and Sweden (Chart 7).
This reform is already underway in Latvia.
This includes public sector policy-related net lending, using foreign borrowing by the Government.
Parliament votes on individual foreign loans but does not consider the associated expenditure as part of a comprehensive fiscal package.
This process is also underway in the other Baltic countries (World Bank 1996b).
