Benchmarking Estonia’s Public Finances-A Primer
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International Monetary Fund. European Dept.
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Emerging needs to strengthen national security and accelerate the energy transition add to longstanding ageing-related pressures. Growing tension between retaining a historically competitive low tax environment and moving towards broader provision of public services and a stronger social safety net may lead to further fiscal deterioration, if left unaddressed.

Benchmarking Estonia’s Public Finances-A Primer1

Emerging needs to strengthen national security and accelerate the energy transition add to longstanding ageing-related pressures. Growing tension between retaining a historically competitive low tax environment and moving towards broader provision of public services and a stronger social safety net may lead to further fiscal deterioration, if left unaddressed.

A. Introduction

1. Recent changes in the global economic and geopolitical landscape have significant implications for public spending. New spending needs stem from the goals to strengthen national security and accelerate the green and energy transition. At the same time, governments face longstanding spending pressures in ageing-related areas such as pensions and healthcare.

2. In Estonia, these pressures have already resulted in a deterioration of public finances. As spending pressures materialize into larger fiscal deficits more recently, there is also a growing debate in Estonian society whether to move closer to an economic model that emphasizes broader provision of public services and stronger social safety nets or retaining a competitive, low tax system which has helped attract investment and create a business-friendly environment. If left unaddressed, this tension may lead to further fiscal slippage.

3. Fiscal pressures are already visible in budget developments. To the extent that some of the new spending is either permanent or contains a strong inertial component, whereas decisions on new revenue measures follow with a lag, unfavorable dynamics for public finance and inefficient policy outcomes in the form of fast increase in public debt and interest payments may ensue.

4. This paper undertakes a high-level benchmarking exercise. Spending categories—by economic concept and by function—and revenue items are compared across relevant regional peers. The goal is to identify levels and trends relative to comparator country groupings—other Baltic neighbors (i.e., Latvia and Lithuania), Nordic countries (i.e., Denmark, Finland, Norway, and Sweden), and the Euro Area (EA20)—that can help identify options of potential expenditure-based consolidation and of revenue mobilization.

B. Expenditures

5. Estonia’s government spending has been relatively low, despite increasing markedly after the Global Financial Crisis (GFC). Estonia’s government expenditures as share of GDP were the lowest among the comparator groups and on a declining trend until 2007 (Figure 1). Despite increasing by almost 3 pp between 2011 and 2023, Estonia’s government was still spending relatively less compared to peers, although broadly in line with the other Baltics.

Figure 1.
Figure 1.

Government Expenditures, 1995–2023

(Percent of GDP)

Citation: IMF Staff Country Reports 2024, 178; 10.5089/9798400278334.002.A004

Sources: Government Finance Statistics, IMF; and IMF staff calculations.

6. Estonia and the Baltics remain among the countries with the lowest government spending in Europe. Over 2017–2023, Estonia’s government spending as share of GDP was on average only higher than that of Ireland, Lithuania, Romania, and Malta, and just below that of Latvia (Figure 2).

Figure 2.
Figure 2.

Government Expenditures, 2001–2023

(Percent of GDP)

Citation: IMF Staff Country Reports 2024, 178; 10.5089/9798400278334.002.A004

Sources: Government Finance Statistics, IMF; and IMF staff calculations.

7. The pandemic led to a temporary increase in Estonia’s government spending which lately resumed. In the five years prior to the pandemic, Estonia’s general government spending averaged less than 38 percent of GDP, about 6.5 and 11 percentage points less than the average of the Euro Area (EA20) and the Nordic countries respectively. In response to the pandemic, spending went up by about 5 pp of GDP, largely reversed in 2021–2022, but spending was on the rise again in 2023. For comparison, in the Nordic countries and the EA20, the post-pandemic decline in government spending as a share of GDP was 8.3 and 4.1 percentage points respectively. By 2023, the gap between Estonia and the Nordics was reduced to 8.5 percentage points of GDP, while remaining about the same in comparison with the EA20. The other two Baltic countries followed a similar profile as Estonia, but with higher spending in Latvia and lower in Lithuania (Figure 3).

Figure 3.
Figure 3.

Government Expenditures, 2015–2023

(Percent of GDP)

Citation: IMF Staff Country Reports 2024, 178; 10.5089/9798400278334.002.A004

Sources: Government Finance Statistics, IMF; and IMF staff calculations.

8. A decomposition of Estonia’s government spending by economic transactions shows a more nuanced picture. While Estonia’s government spends less than the Nordics and the EA20, the relative underspending comes from interests, subsidies, and social benefits, the three categories on the left-hand side of Figure 4. On government consumption (i.e., compensation of employees and purchase of goods and service) and public investment (i.e., capital expenditures), Estonia already outspends the EA20, although it still lags the Nordics (except on capital expenditures).

Figure 4.
Figure 4.

Government Expenditures by Economic Transaction, 2001–2023

Citation: IMF Staff Country Reports 2024, 178; 10.5089/9798400278334.002.A004

9. While being broad-based, the post-GFC increase in Estonia’s government expenditures as share of GDP shows some important differences. Figure 5 highlights a clear rising trend for compensation of employees, capital expenditures, and social benefits. While purchase of goods and services also increased in response to the GFC shock, a more stable path followed afterwards. In contrast, interest expenditures extended their declining trend, given the low public debt. The trend reversed only recently on rising debt and higher interest rates.

Figure 5.
Figure 5.

Government Expenditures by Economic Transaction, 1995–2023

Citation: IMF Staff Country Reports 2024, 178; 10.5089/9798400278334.002.A004

10. The increase in Estonia’s government spending since 2011 is largely explained by capital expenditures, the wage bill, and the cost of social benefits. By 2023, almost all categories of government spending by economic transaction have increased relative to their pre- GFC levels. However, compensation of employees and social benefits—which includes both pensions and employment related benefits—explained about 90 percent of the change, while capital expenditures contributed with 3 pp. In contrast, Nordics and EA20 have reduced total expenditures as share of GDP in almost all categories of spending, and especially in compensation of employees, social benefits, and interests (Figure 6).

Figure 6.
Figure 6.

Change in Government Spending Over 2011–2023

(Percentage points of GDP)

Citation: IMF Staff Country Reports 2024, 178; 10.5089/9798400278334.002.A004

Sources: Government Finance Statistics, IMF; Eurostat; and IMF staff calculations.

11. As Estonia’s per capita income increases, so does the expectation of better coverage and quality of public services. Benchmarking against the Nordics and the EA highlights important structural differences, despite the recent reduction in government spending among these comparators. Figure 7 shows that, except for capital expenditures, Estonia still underspends both the EA20 and the Nordics in all categories of spending by economic transaction. That is especially the case for spending on social benefits, on which the gap is still about 3 pp and 4 pp of GDP respectively.

Figure 7.
Figure 7.

Government Expenditure Differential with Nordics and Euro Area

(Percent of GDP)

Citation: IMF Staff Country Reports 2024, 178; 10.5089/9798400278334.002.A004

Sources: Government Finance Statistics, IMF; Eurostat; and IMF staff calculations.

12. Competing spending pressures emerge. To sum up, Estonia (i) already outspends peers such as the EA20 on public investment and operational costs to provide public services (i.e., compensation of employees and purchase of goods and services), (ii) will experience an increase in interest payments—one category on which Estonia clearly underspends its peers and which will divert resources to debt service, and (iii) may face demand for broader social safety nets and better-quality public services.

13. New spending needs become apparent when assessing Estonia’s expenditures by function. The three charts on the left-hand side of Figure 8 show that Estonia underspends its EA20 and Nordic peers on health and social protection and the EA20 on environment protection. Future demand for these categories of spending is likely to increase due to population ageing and the commitment to the green and energy transition.

Figure 8.
Figure 8.

Government Expenditure by Function, 2001–2022

Citation: IMF Staff Country Reports 2024, 178; 10.5089/9798400278334.002.A004

14. Savings in other areas appear unlikely. Estonia outspends its peers in other categories— defense and education—and the Nordics on R&D—but spending in these areas will unlikely recede, given geopolitical tensions and the need to support the country’s productivity and economic transformation. Moreover, the ongoing decline of spending in education, R&D, and environment protection (Figure 8) make these categories less likely candidates to accommodate higher spending elsewhere.

Figure 9.
Figure 9.

Government Expenditures by Economic Transaction, 1995–2022

Citation: IMF Staff Country Reports 2024, 178; 10.5089/9798400278334.002.A004

C. Revenues

15. Estonia’s low government spending has been met with similarly low government revenues as share of GDP. Over 2017–2023, Estonia’s general government revenue has been on average significantly lower than that of the Nordics and the EA20, albeit slightly higher than that of the other Baltic countries (Figure 10).

Figure 10.
Figure 10.

General Government Revenues, 2001–2023

(Percent of GDP)

Citation: IMF Staff Country Reports 2024, 178; 10.5089/9798400278334.002.A004

Sources: Government Finance Statistics, IMF; World Economic Outlook, IMF; and IMF staff calculations.

16. This relative ranking has also been reflected in historical trends. Following a decreasing trend through 2005, with a trough of 34 percent of GDP, the average government revenue in Estonia permanently increased by about 3 pp of GDP after the GFC, remaining broadly stable at about 38 percent of GDP since then. As of 2023Q2, the Estonian government mobilized 39.3 percent of GDP, still about 13 pp and 4 pp of GDP less than the Nordic countries and the EA20 respectively (Figure 11).

Figure 11.
Figure 11.

Government Revenues, 1995–2023

(Percent of GDP)

Citation: IMF Staff Country Reports 2024, 178; 10.5089/9798400278334.002.A004

Sources: Government Finance Statistics, IMF; and IMF staff calculations.

17. Estonia’s general government revenues have been lower relative to peers even after controlling for per capita income. Results from a time-and country-fixed effect panel regression of total government revenues as share of GDP on real per capita income over the period 2000–2022 can be used to construct a “counterfactual” path had Estonia mobilized revenue in line with its per capita income. Except for 2009–2010, the fitted share of revenues suggests that actual revenue collection is on average 2.7 pp of GDP below what would be expected given Estonia’s per capita income (Figure 12). While recognizing that Estonia’s low, competitive tax system has been serving Estonia well, this result suggests that, along with consolidation efforts on the spending side, space for additional revenue mobilization appears available.

Figure 12.
Figure 12.

Actual and Counterfactual Total Revenues, 2000–2022

(Percent of GDP)

Citation: IMF Staff Country Reports 2024, 178; 10.5089/9798400278334.002.A004

Sources: Government Finance Statistics, IMF; and IMF staff calculations.

18. Tax revenues have generally increased since 2011, except for property and excise duties. Like in the case of government spending and total revenues, a declining trend in tax revenues came to a halt with the GFC. Since then, against the backdrop of relatively stable total revenues as share of GDP the share of tax revenues increased. However, the observed increase (2 percentage points of GDP) fell short of the increase in spending (+ 2.8 pp) over the same period. The increase was also not homogeneous across types of taxes. Revenues from both the personal income tax (PIT) and value-added tax (VAT) increased by about 1 percentage point of GDP between 2011 and 2023, and corporate income tax (CIT) collection increased by about 0.6 pp. On the other hand, already historically low revenues from property taxes have declined further while excise duties generated less 1.5 pp of GDP in revenues since 2011 (Figure 13).

Figure 13.
Figure 13.

Tax Revenues, 1995–2022

Citation: IMF Staff Country Reports 2024, 178; 10.5089/9798400278334.002.A004

19. Relative to peers, Estonia’s tax revenue-to-GDP ratio has been also generally low, although with important differences across types of taxes. While total tax collection by 2022 (last year for which comparable cross-country data is available) was about 4 pp and 16 pp lower than in the EA20 and the Nordics, respectively, revenue levied through excise duties, VAT and social contributions was broadly comparable or even higher than that of Baltic peers, the Nordics, and the EA20 (Figure 14). On the other hand, revenues from personal income taxes and, especially, corporate income and property taxes, were significantly lower than in comparator country groups. Property taxes yield only 0.2 percent of GDP in revenues in Estonia, which is about 4 times less than in the EA20 and the Nordics. Similarly, CIT revenues are 1.7 percent of GDP in Estonia, while four times larger in the Nordics and twice as high in the EA20. Estonia ranks almost last in Europe in both categories of taxes (Figure 15).

Figure 14.
Figure 14.
Figure 14.

Tax Revenues, 2022

Citation: IMF Staff Country Reports 2024, 178; 10.5089/9798400278334.002.A004

Note: Figures on top of selected country data reflects the difference relative to Estonia.
Figure 15.
Figure 15.

Revenues from CIT and Property Taxes, 2001–2022

Citation: IMF Staff Country Reports 2024, 178; 10.5089/9798400278334.002.A004

D. Conclusions

20. Estonia’s public finances face a tension building between historically low taxation and upward-trending government spending. A benchmarking of government spending, both over time and against natural comparators (i.e., Nordics, EA20, and other Baltic peers), suggests emerging spending pressures on defense that add to long-standing ageing-related spending (e.g., health, pensions, and old-age benefits), and expectations of broader provision of public services. At the same time, Estonia’s government revenues have been broadly stable since after the Global Financial Crisis and generally lower than Nordic and European peers.

21. While showing lower spending levels relative to peers, spending is already on an upward trend. Estonia currently underspends comparators on health, social protection, and environment protection—areas that will likely face future spending pressures—and outspends the EA20 average on public consumption and investment. Increasing interest expenditures in the face of larger debt and higher interest rates will continue to divert resources from other areas. Other areas in which Estonia outspends comparators—such as defense, education, and R&D—are unlikely to provide material cost savings given their strategic role.

22. Along with consolidation efforts on the spending side, options for revenue mobilization appear available. Although total tax revenues as share of GDP are generally lower in Estonia than in Nordic countries and the EA20 comparators, tax on consumption (i.e., VAT and excise duties) and labor (i.e., social contributions) are either at par or higher than in those comparator country groupings. On the other hand, less distortionary taxation such as corporate income and property taxes yield significantly less government revenues in Estonia than in both Nordic and European comparators.

References

  • Smith, A. (2021). Public Spending and Revenue Generation in Global Perspective. Cambridge University Press.

  • International Monetary Fund (2019). World Economic Outlook.

  • World Bank (2018). Public Finances in Europe: A Cross-Country Analysis.

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Prepared by Carlos de Resende and Sadhna Naik.

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Republic of Estonia: Selected Issues
Author:
International Monetary Fund. European Dept.