Republic of Estonia: Selected Issues
Author:
International Monetary Fund. European Dept.
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Publication Date:
24 May 2018
eISBN:
9781484357354
Language:
English
Keywords:
ISCR; CR; pay; state; wage growth; minimum wage; EU average; health outcome; IMF government wage bill; public expenditure; education spending; statistics Estonia; Total expenditures; Wages; Europe; Western Europe; Baltics
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Selected Issues

Abstract

Selected Issues

Public Expenditure Efficiency in Estonia1

This Selected Issues Paper assesses the efficiency and effectiveness of public expenditure in Estonia. It benchmarks Estonia’s expenditure levels and composition against peers’, and takes stock of spending outcomes. Although Estonia achieves a generally efficient use of public funds, structural reforms could provide efficiency gains in key areas such as social, health care, and education spending.2

A. Background

1. Estonia faces demographic challenges and structural impediments that hinder a speedier income convergence with Western Europe. Estonia has ample fiscal buffers that could help face future shocks: public reserves exceed gross debt, and the structural balance has been positive since 2009 and only turned into slight deficit in 2017. However, a comparatively low overall capital stock, and imminent and sizeable demographic shifts will impose spending pressures in the years to come.

2. Against this background, this SIP reviews Estonia’s public expenditure to identify potential areas where reform may yield efficiency gains. To get a cross-country perspective, we undertake a benchmarking exercise to compare Estonia’s public spending levels and composition against a set of relevant peers. To gauge the efficiency of public spending, and to identify possible reform areas, we further assess spending relative to outcome measures. Our analysis makes use of both, the economic expenditure classification, which, inter alia, helps assess the distribution of current versus investment spending, as well as the functional classification, which allows for an assessment of the achievement of policy objectives.

3. The authorities started conducting regular in-depth spending reviews in 2016. Fullblown spending reviews are much narrower in focus and thereby allow a more detailed analysis and scrutiny of the effectiveness of certain spending categories. The approach taken in this SIP is a much broader benchmarking exercise, which aims at identifying broad areas for potential efficiency gains. The results presented here should therefore not be seen as a replacement for detailed spending reviews.

B. Public Spending by Economic Classification

4. General government spending is below the EU average, but on par with CESEE countries. Estimated at 40 percent of GDP, total spending has increased by 3 percentage points over the period 2011–16, mostly driven by the public wage bill and social benefits. In the meantime, the EU and CESEE averages have decreased by 2.6 and 1.8 percentage points respectively. Estonia ranks well below the EU average in terms of overall public spending as a share of GDP (Table 1). Spending is mostly driven by current spending, particularly compensation of employees and social benefits. Estonia’s low level of public debt translates into equally low interest payments, which provides fiscal space relative to peers. Spending on compensation of employees, goods and services and public investment is above the EU average, while social benefit spending is below the EU average (Figure 1).

Table 1.

General Government Expenditure by Economic Classification

article image
Note: Capital spending inlcudes gross capital formation and capital transfers. Sources: Eurostat and IMF staff calculations.
Figure 1.
Figure 1.

Public Expenditure in Estonia and Europe

Citation: IMF Staff Country Reports 2018, 126; 10.5089/9781484357354.002.A002

Sources: Eurostat and IMF staff calculations.

Wage Bill

5. The size of the wage bill is close to the European average, but employment levels are relatively high. At 10.8 percent of GDP in 2015, the wage bill is only slightly higher than the European average (Figure 2), and about 1.3 percentage points higher than the CESEE average. However, at 16.4 percent of the working age population, general government employment levels are significantly higher than the European and CESEE averages of 11.9 and 11.4 percent respectively in 2015. At the same time, average wages in the public sector are relatively low as evidenced by a negative public-private wage premium gap (IMF, 2016a, 2016b).3 This could limit the public sector’s ability to attract and retain qualified staff, while severely increasing the overall wage bill should the gap narrow going forward.

Figure 2.
Figure 2.

Public Sector Wage Bill, Employment and Labor Market Implications

Citation: IMF Staff Country Reports 2018, 126; 10.5089/9781484357354.002.A002

Sources: Statistics Estonia, IMF Government Wage Bill and Employment Dataset, and IMF staff calculations.

6. Reducing general government employment could boost labor supply, alleviating pressures stemming from demographic headwinds and an already tight labor market. Labor force participation, currently at about 77 percent, is one of the highest in the EU. Unemployment has decreased to very low levels by historical standards (5.8 percent in 2017) and wage growth has consistently been high, outpacing labor productivity growth in the past years. This has led to rising unit labor cost, which could affect Estonia’s competitiveness (Figure 2). At the same time, Estonia, like many other CESEE countries, is facing severe demographic headwinds making policies aimed at alleviating labor market tightness even more important.

7. Ongoing public-sector reforms should be complemented with further structural measures. A policy to shrink the size of the government sector, targeting a yearly staff reduction of 0.7 percent is in place, and has been overachieved in 2016.4 However, there seems to be room for a faster reduction that would free up labor resources for the private sector. For example, cross-country studies provide evidence of effective policies, such as rationalizing the size and structure of government, outsourcing non-core functions, and improving service efficiency and hiring processes (IMF, 2014). Moreover, downsizing that is part of a reorganization of government services and that targets specific positions and functions, would likely be more successful in achieving permanent reductions in employment than untargeted, across-the-board employment cuts. The literature on civil service reform also suggests that voluntary departure schemes have not been very effective, as they suffer from adverse selection problems (Haltiwanger and Singh, 1999; OECD, 2011; Holzman and others, 2011).

Public Investment

8. Public investment is higher than in most European countries, which is reflected in comparable levels of the perceived quality of the capital stock. Over the past decade, Estonia has consistently had higher public investment rates than the EU as well as CESEE averages, reaching over 5 percent of GDP in 2017.5 The public capital stock still needs some 3 percentage points to catch up with the European average, estimated at about 63 percent of GDP in 2015, while having been 3 percentage points above the CESEE average. The quality of the overall capital stock and infrastructure are perceived to be about the same as for the OECD average, while the quality of air transport, roads and railroads are perceived to be lower. The quality of ports is the only category, in which Estonia scores higher than either the OECD or advanced economies averages (Figure 3).

Figure 3.
Figure 3.

Public Investment, Capital Stock, and Infrastructure Quality

Citation: IMF Staff Country Reports 2018, 126; 10.5089/9781484357354.002.A002

Sources: Eurostat, IMF FAD Expenditure Assessment Tool (EAT), World Economic Outlook, World Development Indicators, IMF Investment and Capital Stock Dataset, World Economic Forum, and IMF staff calculations

9. The policy focus should lie on preserving efficiency in public investment. Due to high public investment rates, supported by EU structural funds, Estonia’s public capital stock will soon have caught up with the EU average. As such, particular focus should be given to preserving efficiency through tight project management and stronger prioritization to avoid leakages and inefficiencies. In addition, attention should be shifted to guaranteeing a sufficient level of maintenance spending in the medium term.

C. Public Spending by Functional Classification

10. Relatively low public spending is reflected across most functional categories. Estonia spent more than the EU average in only the three categories defense (0.7 percentage points of GDP), recreation, culture and religion (0.8 percentage points of GDP), and education (0.9 percentage points of GDP) in 2015 (Table 2). Similar magnitudes apply to CESEE and Emerging Market country averages. Expenditure is particularly lower than the EU average for general public services (2.1 percentage points of GDP), health (0.8 percentage points of GDP), and social protection (3.9 percentage points of GDP). However, the simple comparison with other countries may mask the underlying efficacy of spending in the different categories. The following sections will therefore undertake an outcome-based investigation to identify potential efficiency gains.

Table 2.

General Government Expenditure by Functional Classification

article image
Sources: Eurostat and IMF staff calculations.
uA02fig01

Composition of Public Expenditure in Estonia and in Europe, 2015

Citation: IMF Staff Country Reports 2018, 126; 10.5089/9781484357354.002.A002

Note: Non-social spending = total spending – education -health – social protection.Sources: Eurostat and IMF staff calculations.

Social Protection

11. Low fiscal redistribution is partly responsible for poor social outcomes. The share of the most vulnerable households at the lower end of the income distribution, reflected by the at-risk-of-poverty rate after social transfers, was the highest in Europe for the elderly, and above the EU average for the non-elderly in 2015 (Figure 5). Comparing the improvement of the Gini index induced by the redistribution effect of social spending, Estonia ranks in the bottom quartile in the reduction of income inequality in a ranking of EU countries, slightly lower than the CESEE average.6 With about 70 percent, pensions contribute the bulk of this reduction, which is about 15 percentage points higher than in the EU, but similar to the CESEE average. Direct taxes and social contributions reduce inequality less than the EU average, while means-tested social transfers contribute less to reduce inequality than in any other country in the EU. Nevertheless, the amount of income inequality reduction achieved by 1 percent of GDP of social spending is above the EU average, but slightly below the CESEE average (Figure 5).

Figure 4.
Figure 4.

Social Outcomes

Citation: IMF Staff Country Reports 2018, 126; 10.5089/9781484357354.002.A002

Sources: Eurostat and IMF staff calculations.
Figure 5.
Figure 5.

Health Outcomes

Citation: IMF Staff Country Reports 2018, 126; 10.5089/9781484357354.002.A002

Sources: World Health Organization, Eurostat, and IMF staff calculations.

Contributions to Decrease in Gini

(In percent)

article image
Note: SC= Social Contributions; DT=Direct Taxes; MT=Means -tested social spending; NMT=Non-means-tested social spending. Sources: Euromod and IMF staff calculations.

12. Expanded active labor market policies and improved targeting the poor could lead to better social outcomes, while the scope for increased means testing appears limited. Only about 1 percent of social protection spending is means-tested compared to the EU and CESEE averages of 9.4 and 3.5 percent, respectively. However, careful design of means-tested benefits is necessary to avoid disincentives to work and welfare dependency. This can be achieved through a greater use of in-work benefits and by expanding the role of active labor market programs and strengthening their link to social assistance benefits (IMF, 2012).

uA02fig02

Social Protection spending and means tested spending

(Excluding pensions)

Citation: IMF Staff Country Reports 2018, 126; 10.5089/9781484357354.002.A002

On the flipside, the effectiveness of increased means testing may prove limited as the share of social transfers after pensions and family benefits is only about 20%. Administrative cost of means-testing should also be considered. On the spending side, priority may be given to improving social safety nets and increasing social transfers, especially for the elderly as public pensions, being the most redistributive tool in Estonia, do not provide sufficient replacement income to protect against the risk of poverty. This is reflected in a comparatively low benefit ratio (around 30 percent), which is expected to further decline in the medium to long run (Carone et. al., 2016).7

13. Reforms to improve the income redistribution are underway. As part of the income tax reform, the 2018 budget includes an increase of the basic allowance to the level of the minimum wage of EUR 500—about 55 percent of the average wage. It will increase the disposable incomes of workers in the lower segment of the income distribution. In particular, the authorities estimate the new basic allowance to increase the net wage of low wage workers up to 15 percent. Overall, the change in the basic allowance is estimated to generate a revenue loss of around 0.8 percent of GDP in 2018. A planned pension reform is aimed at preventing old-age poverty by guaranteeing a minimum pension. Main elements of the reform include: (i) shifting the calculation basis for the first pension pillar, financed out of social tax revenue, from level of income to years worked by 2037; (ii) tying the national retirement age to the average life expectancy in 2027; and (iii) abolishing special pensions of certain groups by 2020. The government also increased monthly benefits for families with many children in July 2017 to an additional EUR 300 for families with three children, and EUR 400 for families with seven or more children.

Health

14. Health spending is currently low, but mounting demographic pressures will likely lead to longer-term cost pressures. At about 5.5 percent of GDP in 2015—about ½ percentage point higher than in 1990—health spending is about ¾ of a percentage point of GDP lower than the EU average, but on par with the CESEE average. In PPP-adjusted terms, Estonia spent about USD 1,670 while the EU average was about USD 3,100 in 2014. However, the projected increase in the old-age dependency ratio from 28 percent in 2013 to 54 percent by 2060 (EC, 2015) will likely exert upward pressure on spending considering the high cost of treating the elderly, in particular as advances in healthcare technology introduce better, but more costly treatment options and health care demand is typically very responsive to income growth.

uA02fig03

Government Health Expenditure, percent of GDP

(Outlier excl.)

Citation: IMF Staff Country Reports 2018, 126; 10.5089/9781484357354.002.A002

15. The share of doctors and nurses working in hospitals is comparatively high. With 65 percent, the share of doctors working in hospitals is about 10 percentage points higher than the EU average (7 percentage points higher than CESEE), while the share of nurses is about 8 percentage points higher (10 percentage points higher than CESEE). Hospital services are generally costlier than, for example, primary care services.

uA02fig04

Health Structural Inputs

Citation: IMF Staff Country Reports 2018, 126; 10.5089/9781484357354.002.A002

Source: World Health Organization

16. An assessment of Estonia’s health outcomes using WHO data indicates that there is room for improvement. The Health-Adjusted Life Expectancy (HALE) at birth is about 69 years compared to over 70 years for the EU average, but is higher than in the three Baltics (Latvia 67 years; Lithuania 66 years) (Figure 6).8 Few countries achieve a similar or higher outcome with a lower per capita spending. Nevertheless, WHO data show that there is room for improvement in some areas: crude deaths exceed the EU average by about 20 percent, diseases of the circulatory system, and ischemic heart diseases both by about 37 percent, external injuries/poisoning by about 59 percent, alcohol-related diseases by about 45 percent, and smoking-related diseases by about 10 percent. This is also reflected in the self-perceived level of good health as reported by Eurostat, which is lower in the category “Good or very good” than to the EU average for all income levels. Moreover, health outcomes are not evenly distributed within the population as the self-perceived level of good health comes close to the EU average only for the richest two quintiles.

Figure 6.
Figure 6.

Education Spending

Citation: IMF Staff Country Reports 2018, 126; 10.5089/9781484357354.002.A002

Sources: Eurostat, World Economic Outlook, and IMF staff calculations.

17. A Data Envelopment Analysis9 also suggests that further efficiency gains are possible. The distance to the efficiency frontier, i.e. to the best-in-class result for a given level of spending, is about 4 years of HALE. Many of the causes of poor health outcomes, which are mainly driven by behavioral health risks could be addressed by strengthening the primary health care system and through an effective public health intervention and prevention agenda (OECD, 2017). Consequently, a considerable share of acute inpatient care could be shifted to more suitable (and lower cost) settings (World Bank, 2015), for example, by reducing the excessive reliance on the hospital sector, which generally proves costlier than primary care. Also, medical training could (i) move away from narrow disease-oriented specialization to teaching more general skills, and (ii) intensify the promotion of continuous education as a way of re-skilling the workforce (OECD, 2017). However, a declining working-age population will make increasing the efficiency, while ensuring the sustainability of the health system, challenging as the health system is mainly financed through payroll taxes. This also applies to guaranteeing a sufficient level of qualified human resources, in particular as the ratio of nurses to doctors in the health care system is still below the EU average (Figure 6).

18. Ongoing reforms are, inter alia, seeking to consolidate the hospital system. Since 2014 efforts have been made to create networks between regional and general hospitals to share access to specialist expertise and resources. A [limited number] of networks was operating in 2017. Moreover, recent excise tax hikes on tobacco and alcohol were aimed at changing risk behaviors and investments in e-health systems are aimed at creating efficiency gains. Guaranteeing a sufficient level of human resources has partly been addressed by increasing the role of nurses and midwives.

Education

19. Controlling for income levels, education spending is high relative to the EU and CESEE averages. Education spending was about 0.9 and 1.2 percentage points of GDP higher than the EU and CESEE averages in 2015, respectively. Higher spending is also reflected across almost all education spending categories when compared to CESEE, and the difference with the EU being highest for Goods & Services (1.3 percent higher) and capital spending (0.8 percent higher) (Figure 7). The decline over the period 2010–15, however, was similar to the decline of the EU average (0.5 percentage points for Estonia vs. 0.4 for the EU) (Table 2).

Figure 7.
Figure 7.

Education Outcomes

Citation: IMF Staff Country Reports 2018, 126; 10.5089/9781484357354.002.A002

Sources: IMF FAD Expenditure Assessment Tool (EAT) and World Bank.1/ Dash lines are the average of EU.

20. The high level of spending is reflected in high education outcomes. The teacher-student ratio exceeds the EU average by 1.1 for primary education and 2.4 for secondary education and the CESEE average by 1.5 and 2.1, respectively. The net school enrollment ratios are only slightly above the EU average and about 3 percentage points above the CESEE average for both primary and secondary education. Accordingly, the distance to the frontier is about 3 years for primary education and 7 years for secondary education in terms of net enrollment (Figure 7). Net school enrollment, given the current level of per student spending in PPP USD terms, is also still about 3 years away from the efficiency frontier for primary schooling and about 8 years for secondary schooling. In short, other countries achieve a higher net school enrollment with fewer resources. PISA scores on the other hand, are consistently higher than the 75th percentile of the EU and CESEE averages for all components of the overall score, i.e. math, reading and science.

uA02fig05

PISA Score, 2015

Citation: IMF Staff Country Reports 2018, 126; 10.5089/9781484357354.002.A002

Sources: World Bank

21. Reform priorities should focus on increasing the efficiency of education spending in light of demographic challenges and economic needs. As education outcomes are good, reforms should focus on achieving efficiency gains in the supply of education services while maintaining a high level of education outcomes. Estonia also needs to further develop the skills required to become a technology-intensive economy (OECD, 2016). Teaching will also need to be made more attractive to avoid a future shortage of quality teachers, which is currently being addressed by the government through targeted wage increases for teachers. At the same time, Estonia’s education system needs to adapt to the declining numbers of students, which will require redefining and coordinating the allocation of education resources.10 However, the scope for savings through consolidation may be limited by the need to provide basic education within a reasonable commuting distance for students, requiring more teachers and schools per student in less populated areas. The education system should also aim to address mismatches between job needs and skills.

22. Recent reforms have changed teachers’ remunerations to make the profession more attractive. Teachers’ base salaries were changed from contact hours to general working time, and more autonomy was given to school principals to set the salary of individual teachers. Also, beginning with the 2013/2014 academic year, higher education was made free of charge for students studying full time in Estonian. Moreover, the government is implementing a reform to improve school-transport for students, which will help consolidate regional education supply. The ongoing administrative reform could also help municipalities organize their school systems more efficiently.

D. Policy Implications

23. Better outcomes should be achieved in a budget-neutral way where possible. Given already relatively low spending levels, improving social outcomes, in particular old-age poverty, may prove difficult to achieve only by cutting spending elsewhere. In combination with spending pressures, which will inevitably arise with an aging population, achieving better outcomes in a budget neutral way may necessitate broadening the tax base.

24. Estonia achieves a generally efficient use of public funds, with some key differences across sectors, but further efficiency gains are possible. With 40.4 percent of GDP Estonia ranked well below the EU average of 43.9 percent, but similar to the CESEE average in 2016. Spending is mostly driven by current spending, particularly compensation of employees and social benefits. Most outcome-based measures of the achievement of policy objectives indicate that public spending achieves satisfactory results, yet further reforms in the following areas could provide additional efficiency gains:

  • Reducing general government employment could be done faster to free up labor resources for the private sector. This should be complemented with further structural measures.

  • Particular focus should be given to preserving efficiency in public investment through tight project management and stronger prioritization to avoid leakages and inefficiencies.11

  • Social spending could be made more efficient through better targeting the poor, greater use of in-work benefits and by expanding the role of active labor market programs and strengthening their link to social assistance benefits.

  • Efficiency gains in the health sector can be achieved by rebalancing toward primary and preventive care, and shifting acute inpatient care to lower-cost settings, while ensuring the sustainability of the health system in light of demographic challenges.

  • Reforms of the education sector should focus on achieving efficiency gains in the supply of education services while maintaining a high level of education outcomes. At the same time, Estonia’s education system needs to adapt to the declining numbers of students.

References

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  • Charnes, A., Cooper, W., and Rhodes, 1978, E. “Measuring the Efficiency of Decision Making Units.” European Journal of Operational Research.

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  • European Commission and Economic Policy Committee, 2015, The 2015 Ageing Report: Economicand Budgetary Projections for the 28 EU Member States (2013–60), (European Commission: Brussels)

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  • Farrell, M. J., 1957, “The Measurement of Productive Efficiency”. Journal of the Royal Statistical Society.

  • Haltiwanger, J., and M. Singh, 1999, “Cross-Country Evidence on Public Sector Retrenchment,” World Bank Economic Review, Vol. 13, No. 1, pp. 23–66.

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  • Holzmann, R., Y. Pouget, M. Vodopivec, and M. Weber, 2011, “Severance Pay Programs around the World: History, Rationale, Status, and Reforms,” IZA Discussion Paper No. 5731 (Bonn: Institute for the Study of Labor).

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  • International Monetary Fund, 2012, “Fiscal Policy and Employment in Advanced and Emerging Economies,” Policy Paper (International Monetary Fund: Washington)

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  • International Monetary Fund, 2014, Public Expenditure Reform: making Difficult Choices, Fiscal Monitor, 90 p., (International Monetary Fund, Washington).http://www.imf.org/external/pubs/ft/fm/2014/01/pdf/fm1401.pdf.

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  • International Monetary Fund, 2016a, “IMF FAD Public-Private Wage Premium Dataset,” (International Monetary Fund: Washington).

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  • Liu, C., & Garcia-Escribano, M., 2017, “Expenditure Assessment Tool 1,” Expenditure Assessment Tool.” (International Monetary Fund: Washington).

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1

Prepared by Andreas Tudyka. The author would like to thank the Estonian authorities, and the participants of a seminar at the Central Bank of the Republic of Estonia, and the IMF’s Fiscal Affairs Department and in particular Mercedes Garcia-Escribano, and Maximilien Queyranne for helpful comments and suggestions.

2

The analysis in this SIP is based on the Expenditure Assessment Tool (EAT) and the European expenditure template developed by the IMF’s Fiscal Affairs Department (Liu and Garcia-Escribano, 2017).

3

Public-private wage differential (as a percent of private wage): based on a review of regression studies that control for skill differentials between the public and private sector. Numbers are calculated by taking the within-country average over time.

4

The government has pledged to keep government employment in full-time equivalent terms pegged at 12 percent of the population aged 15–74 years.

5

Estonia is a major recipient of the European Structural and Investment (ESI) Funds (European Regional Development Fund, European Social Fund, Cohesion Fund, European Agricultural Fund for Rural Development, European Maritime and Fisheries Fund) and is allocated EUR4.5 billion during the 2014–20 budget period.

6

The Gini index reduction measure of efficiency, calculated by Eurostat using EUROMOD, compares the market income (pre-redistribution, i.e., pre-tax-and-transfer) Gini index with the disposable income (post-redistribution, i.e., post-tax-and transfer) Gini index concentration of income inequality. At a maximum concentration, the index is 1, at absolute equality of incomes it is zero.

7

Occupational and private individual schemes that may help support retirees’ income are excluded.

8

HALE adjusts standard life-expectancy measures for severity of illnesses and quality of life factors. Other factors, such as the quality of the health care environment and financial risks, are not taken into account.

9

Developed by Farrell (1957), see also Charnes, Cooper, and Rhodes (1978). This approach relies on the calculation of a ‘best practice’ frontier comprising countries which display the optimal combination of inputs and outcomes. The distance from the frontier provides for all countries an efficiency score that can be used to estimate potential gains by improving efficiency to best-performer levels. The bigger the distance to the efficiency frontier, the more inefficient a country is in providing health services. DEA calculation outcomes are influenced by sample selection and measurement issues, and outliers can have a substantial impact on efficiency scores.

10

The EC’s 2015 Ageing report projects substantial decrease in the number of students in primary education over the period 2013–60.

11

Also see the Selected Issues Paper “Public Investment Management in Estonia: Key Institutions and Reform Priorities.”

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Cover IMF Staff Country Reports
Republic of Estonia: Selected Issues
Author:
International Monetary Fund. European Dept.
Volume/Issue:
Volume 2018: Issue 126
Publisher:
International Monetary Fund
ISBN:
9781484357354
ISSN:
1934-7685
Pages:
55
DOI:
https://doi.org/10.5089/9781484357354.002
Figure 1.

Public Expenditure in Estonia and Europe
Figure 2.

Public Sector Wage Bill, Employment and Labor Market Implications
Figure 3.

Public Investment, Capital Stock, and Infrastructure Quality

Composition of Public Expenditure in Estonia and in Europe, 2015
Figure 4.

Social Outcomes
Figure 5.

Health Outcomes

Social Protection spending and means tested spending

(Excluding pensions)

Government Health Expenditure, percent of GDP

(Outlier excl.)

Health Structural Inputs
Figure 6.

Education Spending
Figure 7.

Education Outcomes

PISA Score, 2015