Zuzana Smidova
OECD Economic Surveys: Estonia 2024
Abstract
Economic growth recovered strongly from the pandemic, surpassing pre-pandemic levels at the end of 2020. Impacted by a surge in energy prices, disruptions in trade with Russia, tightening monetary conditions and a weakening in key Nordic markets, Estonia has experienced a relatively severe downturn and the near-term growth outlook is weak. Household incomes have been hit hard by high energy prices and, while the labour market has held up well, unemployment has started to rise. Inflation is easing, despite a VAT increase early this year. Fiscal policy supported the economy through the pandemic and the energy crisis but is becoming restrictive as the government aims to rebuild fiscal buffers. The financial sector is sound, although risks have increased. Despite low government debt as a share of GDP, there are fiscal pressures including from population ageing, health needs, higher defense spending and the climate transition.
Estonia’s macroeconomic stability has long supported income convergence. Prudent monetary and fiscal policies have helped to ensure stability within the euro area and attracted considerable foreign direct investments, in sectors such as telecommunications and finance. While activity recovered strongly from the COVID-19 pandemic, the economy experienced the highest inflation rate of the euro area as energy prices rose sharply. The economy has gone through a relatively severe downturn due to the impact of high interest rates, substantial negative shocks from disruptions to trade with Russia and weaker demand for Estonian products from the Nordic countries. With inflation subsiding but an economic contraction underway, fiscal policy needs to carefully balance rebuilding of fiscal buffers with stabilisation of the economy and inclusiveness.
The economy has contracted since the outbreak of war in Ukraine
With a sharp post-pandemic rebound, the Estonian economy surpassed its pre-pandemic output level at the end of 2020. Nevertheless, since the outbreak of war in Ukraine, it has been in a relatively severe downturn due to the impact of disruption of trade in the east, the surge in energy prices, the slowdown in Nordic export markets and the impact of tighter monetary policy (Figure 2.1). In the fourth quarter of last year output was 6% below its post-pandemic peak in the fourth quarter of 2021 and a sizeable negative output gap has opened up. Private consumption has been falling since the second quarter of 2022 in volume terms and is now 1 percent below its peak, even though it has been supported by a rundown of pandemic savings and private pension funds withdrawals. Increased uncertainty has been reflected in falling investment, although public investment has expanded and housing investment has held up. Business and consumer confidence remain subdued and other short-term indicators paint a mixed picture.
Although trade with Russia and Belarus represented only 10% of imports and 4% of exports in 2022, Russian imports were used in 40% of Estonian exports, notably in transport, wood, chemicals, manufacturing and fuel re-exports, leading to considerable disruptions in exporting industries since the start of the war (Eesti Pank, 2022a). Firm-level analysis of the initial impact of European sanctions on Russia showed a fall in the number of jobs, export volumes and an increase in prices among firms that imported from Russia, even before all embargo measures were fully phased in (Eesti Pank, 2022a). The slowdown in Nordic export markets for construction materials has added further strain as weakening of their housing markets spilled over to Estonian manufacturing exports, notably of construction services, wood and furniture. The current account balance has deteriorated sharply, from a pre-pandemic surplus of 2.3% of GDP in 2019 to a deficit of 3.6% in 2022 due to weaker exports and higher energy imports (Figure 2.1).
Source: OECD National accounts; OECD Analytical Database.
Headline inflation peaked at a high rate but is easing
Following the surge in energy prices, headline inflation peaked at 25% in August 2022, the highest level in the euro area, but it has declined steadily to 4.1% in March this year. Inflation started to pick up in the pandemic recovery due to supply bottlenecks and strong demand as in many other OECD countries. Energy prices peaked at more than twice their pre-pandemic levels, while electricity prices remain more than three times higher. Energy and food have a larger share in the CPI basket than on average in the euro area (Eesti Pank, 2022). Estimates of the pass-through from global commodity prices and, in particular food, also show a more sizeable impact than in the euro area or Latvia and Lithuania (IMF, 2022).
Inflationary pressures have spilled over to the wider economy, although a significant part of the increase in core inflation appears to have originated in higher prices of energy and food. Core inflation peaked at 13% in October 2022 and fell to 4.9% in March this year. Input-output analysis suggest that a substantial share of the initial rise in core inflation can be explained by the higher cost of energy inputs feeding indirectly into the cost of other goods and services with food playing a similar role more recently (Figure 2.2). At the same time, price increases were higher than usual in other sectors. Higher inflation can partly be accounted for by higher unit profits, although much of this initially reflected higher profits in the energy sector (Eesti Pank, 2023a). A VAT rate increase of 2 percentage points at the beginning of 2024 has been passed to prices only partly so far, primarily affecting prices of food, alcohol and tobacco, with year-on-year inflation increasing in January compared to the previous month (Eesti Pank, 2024).
Labour costs have increased substantially and more rapidly than in past years, notably in the first half of 2023, on the back of increases in the minimum wage and public sector wages (teachers, healthcare, police and the armed forces). In 2023, wages grew by around 11%, above the inflation rate of 9.1%, as they caught up with past inflation developments. The minimum wage, set by a collective agreement between the trade unions and employers, increased by 11% in 2023 and is set to rise by a further 13% this year. These increases could spill over into wider wage and price pressures. However, private sector wage growth appears more muted, especially in sectors such as manufacturing and construction directly exposed to the weak external environment (Eesti Pank, 2023d). The current weak state of the economy and low level of unionisation increase the likelihood that inflation will return to normal rates.
Source: OECD Consumer prices indices (CPIs) database.
Household incomes have been hit hard by high energy prices and households are dissaving
High inflation and modest wage increases have hit household consumption, although this has been partly cushioned by running down of savings. Real disposable incomes have fallen by more than in most OECD countries given the exceptionally high inflation. By 2023, real wages were more than 15% lower than in 2021 (Figure 2.3). The housing cycle has turned and mortgage-holders are facing much higher interest rates with relatively fast transmission of higher euro policy interest rates. Households have been able to cushion some of the inflation impact with savings accumulated during the pandemic. In addition, the second pension pillar became voluntary in 2021 and households are now able to withdraw savings before reaching the retirement age. A third of participants withdrew a total of over EUR 2 bn by the end of 2023, around 5.3% of GDP. In the initial year, a fourth of those savings were used for consumption, another fourth remained as deposits and a tenth of the funds were used for debt repayments (ERR, 2023). Those exiting the pension pillar were households with no financial buffer, who tended to have large unsecured loans or faced credit constraints, and this creates risks for future retirement incomes. As a result of these developments, the household savings rate has turned sharply negative and household spending has increased 9 percent since the second quarter of 2022, adding to the inflationary pressures, although it has fallen by 3 percent in real terms by mid-2023.
Source: OECD Analytical Database.
Income inequality, measured by Gini index, is comparable to the Baltic neighbours, but higher than among the Nordic countries or those of the Central European that are sometimes taken as peers (Figure 2.4). Relative poverty, measured by the share of population at risk of poverty or social exclusion, is above the EU average.
In 2022, 22.5% of population lived on less than 60% of the median household income (Statistics Estonia, 2023b). Old-age poverty is an issue, in particular for single pensioners. 28% of those over 65 years live below the poverty line, defined as half of the equivalised household income, and this share is almost 80% for single pensioner households. 14.6% of Estonians of working age lived below the poverty line of 50% of household income, with mean income 35% below half of the equivalised household income.
Income inequality has been on a declining trend since 2014, both due to declines in market inequality, as well as increased redistribution. Nevertheless, income growth of those at the bottom of the distribution has been lagging and the share of people at risk of poverty has increased during 2019-22, in particular for the elderly and inactive (Statistics Estonia, 2023b; IMF, 2022).
Wealth inequality increased between 2013 and 2021 and is more pronounced than income inequality with a Gini coefficient of net wealth at 0.71 (Merikull and Room, 2023). Estimates imputing the top wealth values, that are often underrepresented in wealth surveys, raise the Gini index to 0.75 (Brzezinski et al, 2019). In Estonia, the top 5% of wealthiest households held around 48% of net assets, compared to 38% for the OECD average, signalling high concentration of wealth.
Note: Data were not available for Korea and a breakdown of wealth held by the top 10% was not available for New Zealand. The data on net private household wealth does not include occupational pensions, which are an important component of the wealth portfolio of households in some countries, for example in the Netherlands and Denmark.
Source: OECD Income distribution database; OECD Wealth Distribution Database.
The labour market has remained strong
Despite the slowdown of economic activity, the labour market has remained strong. The employment rate surpassed the pre-pandemic level in 2022 and has reached 76.6%, substantially above the OECD average of 70%. Most of the recent employment growth has come from increasing part-time work, popular among the young, women and the older workers, as it became possible to combine work with receiving disability and parental benefits, and as the retirement age continues to increase (Eesti Pank, 2023b). Falling household incomes may have also contributed to increasing labour supply. However, employment rates among the young and men remain below 2019 levels. Having peaked at just under 7% in June 2020, the unemployment rate declined to 5-6% during the recovery. It started to rise again at the beginning of 2023, reaching 6% in December, although part of the increase can be accounted for by the inclusion of Ukrainian refugees in the labour force statistics. The job vacancy rate, high prior to the pandemic, subsequently recovered after the pandemic, but has also eased in recent months (Figure 2.5).
Estonia has experienced a large inflow of Ukrainian refugees. The number of Ukrainians living in the country increased more than three times since the outbreak of the war to around 48 000, accounting for 3.6% of the population. With 67% of refugees of working age, this has increased the workforce by 4% (Foresight Centre, 2023a). Half of the refugees of working age are employed, often in basic occupations and below their qualifications, pointing to a skills mismatch as a large majority of the refugees have middle or higher education (Statistics Estonia, 2023a). This situation is common across OECD countries (OECD, 2023f). Early labour market entry of refugees, especially in lower-skilled jobs, should be accompanied by training opportunities and continued counselling to facilitate the transition into sustainable employment commensurate with their education and skills (OECD, 2023c).
Source: OECD Short term labour market statistics; and Eurostat.
A recovery is expected to begin this year
The economy is projected to contract by 0.4% this year, reflecting continued weak demand at the beginning of the year (OECD, 2024). Inflation will continue falling steadily to 3.9% this year as a policy-induced rise is expected due to VAT increase, estimated by authorities to contribute 1.5 percentage points in 2024 (Ministry of Finance, 2023). Next year inflation is projected to fall to 2.1%. Mortgage rates, closely linked to market rates, may be more stable going forward, although lower inflation will raise interest rates in real terms. The fiscal stance will turn contractionary as consolidation measures set take effect this year. In 2025, corporate and income tax rates are set to increase. Real GDP growth should strengthen in 2025 to 2.6% as the recovery progresses both domestically and abroad, and as Estonia draws on available EU funds (Table 2.1). The unemployment rate is likely to continue increasing this year to 7% and fall to 6.8% the year after.
Note: Data from 3Q 2023 are based on current economic projections, except for Estonia.
Source: OECD Economic Outlook 115 database.
Note: 1. Contributions to changes in real GDP, actual amount in the first column.
1. Harmonised index of consumer prices excluding food, energy, alcohol and tobacco.
2. The Maastricht definition of general government debt includes only loans, debt securities, and currency and deposits, with debt at face value rather than market value.
Source: OECD Economic Outlook 115 database.
Estonia has experienced a series of negative shocks, and risks to the outlook are tilted to the downside. A more protracted than anticipated slowdown in Nordic export and housing markets, an escalation of geopolitical tensions in the region or a large-scale cyberattack, given the prominence of digital activities in the Estonian economy, could impair recovery. One of the key questions is how quickly construction-related production will be able to find new markets, outside the Nordic region. A stronger domestic housing correction or an increase in household saving could complicate the outlook for domestic demand. On the other hand, a stronger than expected recovery in the regional economy or lower than anticipated interest rates could lead to stronger growth.
Financial stability risks have increased, but the financial sector appears sound. The banking sector, with assets of around 134% GDP in 2022 and dominated by foreign-owned banks, is well capitalized with sound liquidity ratios and a low share of non-performing loans (Figure 2.7). Several macroprudential measures have been in place since 2015 (Table 2.3). Lending growth surpassed nominal growth of the economy during 2021-22, leading the authorities to increase the counter-cyclical capital buffer from 1% to 1.5% in December 2023 and resulting in tightening of credit standards (Eesti Pank, 2023b).
The sector remains highly concentrated, with the three largest banks holding 75% of all assets in 2022, although smaller banks have grown strongly over recent years (Eesti Pank, 2023b). A recent analysis by the central bank and Financial Supervision Authority suggests that, despite the high concentration of the banking market, access to loans has not been an issue in recent years (Eesti Pank and Finantsinspektsioon, 2024). Nevertheless, competition could be increased, for instance by lowering transaction costs of refinancing housing loans, improving access to standard conditions for housing loans or mandating alternative reference rates (Eesti Pank and Finantsinspektsioon, 2024).
Source: IMF Financial Soundness Indicators (FSI) database.
Credit risk has increased as interest rates have risen and growth has slowed but it appears manageable. The central bank’s stress testing exercise is based on a 6-month Euribor rate of 5% (around 1 percentage point above the current rate) and unemployment rising to 13.6%. This would lead to the share of overdue loans increasing to 3.3% for consumer loans and to 0.8% for housing loans (Eesti Pank, 2023c). For context, during the housing market correction following the 2008 Global Financial Crisis, when house prices fell by over 40%, the share of non-performing housing loans reached 4.5% in 2010. At the same time, banks are exposed to risks in the commercial real estate. Corporate loans to real estate companies represent 37% and 18% of loans to the non-financial sector, while the activity in this sector has been muted over the past year (Eesti Pank, 2023c). Given that corporate taxation favors retention of profits, Estonian firms have considerable capital buffers.
Source: Eesti Pank (2023b).
Nominal average house prices have been relatively flat for almost a year, following a surge after the pandemic. In real terms and relative to incomes, the housing market is undergoing a mild correction and the authorities estimate that house prices are overvalued by 5% (Eesti Pank, 2023c) (Figure 2.8). House prices have failed to match inflation for most of the past year. As interest rates rose and the economy slowed, both the number and value of transactions fell in 2023 (Global Property Guide, 2023). Nevertheless, housing investment has been relatively resilient, continuing to grow in year-on-year terms for much of 2022 and 2023. The mortgage stock remains relatively low at 37% of GDP compared to 52% at the peak in 2008. Home ownership is high, with 76% of households living in owner-occupied housing and the rental market is small. The house price-to-income ratio stands close to the OECD average: to buy a 100m2 dwelling, a household requires 10 years of disposable income. Difference between house prices in the metropolitan region, where around 40% of population lives, and that in far-off rural areas reached 50% in the first half of 2021, is one of the largest in Europe, restricting the potential for labour mobility (OECD, 2022b).
Source: OECD STI Short term indicators database.
Non-bank financial institutions play a limited role in the Estonian financial system. The stock market is small, with a capitalisation of 13% of GDP in 2022 and 20 listed companies. An alternative market exists, “First North Alternative”, although this too has a modest size with just 13 Estonian companies listed. At 12% of GDP in 2022, pension funds’ assets have been decreasing following a policy change in 2021 that turned the second pillar into a voluntary savings scheme. Some risks exist in savings and loan associations that hold deposits of around 0.4% of GDP and lend mainly to businesses as not all of them have sufficient capital and liquidity buffers. The authorities are working on tightening oversight by obliging them to apply for authorisation on the same basis as other credit institutions (Eesti Pank, 2023b).
The tightening of euro area monetary policy has passed rapidly through into domestic financial conditions. The general government posted a deficit of 3.4% in 2023. The government debt ratio remains the lowest in the OECD, but is significantly higher than it was prior to the pandemic due to COVID and energy-related measures as well as some permanent budgetary changes (Figure 2.9). Given the downturn and conditional on inflation pressures remaining low, fiscal policy should be supportive of growth in the near term, while focusing on narrowing the deficit in the medium term and managing longer-term fiscal pressures.
Since a considerable pro-cyclical fiscal tightening during the Global Financial Crisis of 2008-09, when Estonia effectively did not have access to financial markets, fiscal policy has been broadly neutral, although considerable volatility of the output gap estimates complicates such an assessment (Figure 2.9). During the pandemic fiscal policy supported the economy, leading to a sizeable government deficit. With the onset of the war in Ukraine and the energy crisis in 2022, a supplementary budget of around 3% GDP provided resources for the integration of Ukrainian migrants and to mitigate the impact of increased energy prices. Energy-related fiscal measures reached around 1.8% of GDP over 2021-23. At the same time, significant permanent increases in spending were put in place. National security spending increased from 2% in 2020 to 2.8% in 2023. Increases in social benefits, pensions and the tax allowance during 2020‑23 helped to raise the incomes across the distribution: the lowest income households by 7.5% and by 0.8% the highest income decile (Ministry of Finance, 2023b). While this social spending supported demand, it has come at a cost. The impact of fiscal policy in 2023 was broadly supportive.
Note: In Panel A 2024 and 2025 corresponds to Economic Outlook 115 projection.
Source: OECD Economic Outlook 115 database.
A consolidation of 0.75 % of GDP is under way this year. The authorities are clawing back some of the past family benefit increases, and VAT and excise tax rates have been increased, although 0.3% of GDP is of a temporary nature based on taxes on the banking sector (Box 2.2). The authorities estimate general government deficit of 3.5% of GDP this year. Rebuilding the fiscal buffers is a key objective of the government and the domestic fiscal rules, which largely mirror the existing EU fiscal rules, require yearly consolidation until it reaches a structural deficit of -1% of GDP but allow for postponement in economic downturn. OECD estimates suggest that a part of the budget deficit is cyclical, given the scale of the downturn. Although there is uncertainty about the permanent impact of the trade shocks on potential output, a part of the budget deficit appears to be structural and would need to be reduced in the medium term to comply with the fiscal rules. This reflects an earlier increase in family benefits in the magnitude of 0.5% of GDP, a permanent increase in defense spending, which has already risen by 0.8% of GDP, and debt-servicing costs, expected to rise by 0.5% of GDP between 2022 and 2024 (Table 2.6).
Based on a fiscal strategy approved in the spring of 2023 and measures that have been legislated so far, most of the consolidation for 2024 and 2025 is concentrated on the revenue side. Spending reviews by individual ministries are planned and have been so far completed by three line ministries (Ministry of Finance, Ministry of Social Affairs and Ministry of Economy). The fiscal strategy suggests expenditure savings annually between 0.3-0.6% of GDP.
Source: Ministry of Finance, April 2024 and August 2023 Macroeconomic forecast.
The government’s fiscal strategy announced in the spring of 2023 aimed for headline deficit of 2.8% in 2024, 1.9% in 2025 and 1.2% in 2027 but was based on macroeconomic assumptions that turned out too optimistic (Ministry of Finance, 2023c). Next year, corporate tax on distributed profits and personal income tax (PIT) rates will increase although other changes in the PIT will result in a revenue loss of 0.86% of GDP (Box 2.2). Several revenue raising measures have been agreed, such as new motor vehicle tax but not yet legislated. To reach the initial budgetary strategy targets around 1% of GDP of consolidation effort remains to be identified for 2025. OECD projections include all legislated measures as well as the new car tax and savings from spending reviews. This year, automatic stabilisers should be allowed to work freely, although their size is limited due to a small size of the government, limited progressivity of the tax system and modest unemployment benefits. A recent reform of the unemployment benefit made its duration dependent on the labour market situation. The structural budget deficit will ultimately have to be reduced, and maintaining low debt is welcome in such a small and volatile economy. The downturn, currently concentrated in several sectors, and weak outlook call for caution in pressing ahead with consolidation in the near term. For 2025, a careful balance will need to be struck between any fiscal adjustment and the state of the economy at the time.
General government, % of GDP
Note: Other items includes public order and safety, housing and community amenities, recreation, culture and religion, environmental protection.
Source: OECD National Accounts database.
EU funds provide a considerable funding for public investment and other policies, with up to 1.8% of GDP available annually over the period of 2021-26, including both from Recovery and Resilience and Cohesion funds. These estimates depend on national capacity to implement the policies, but Estonia has a good track record of successfully drawing EU structural funds. While cost-benefit analysis is applied for EU funded projects, there is no standard appraisal methodology and a comprehensive pipeline of investment projects for domestic programmes (IMF, 2019). Given elevated planned investment spending, it is important that a sound cost-benefit analysis is used systematically.
Fiscal policy in Estonia is guided by the domestic fiscal rules, which have largely mirrored the provisions of the existing EU fiscal rules and have strong national ownership. The reform of the EU fiscal rules is likely to make them less constraining for Estonia as a low debt country, which increases the onus on the domestic framework (OECD, 2023i). The current government lowered the medium-term objective (MTO) to a structural deficit of 1% of GDP rather than 0.5% as was the case prior to the pandemic, which implies a somewhat faster increase in the debt ratio. The fiscal rules were amended last year to be able to take into account exceptional circumstances, such as economic downturns, and to reinforce the domestic objective for the structural balance. According to the revised rules, the required minimum structural deficit would revert to 0.5% of GDP in 2030 or if the general government debt (Maastricht definition) reaches 30% of GDP. Current macroeconomic analysis of the cyclical position of the economy supplements the output gap measure based on the EU Commonly Agreed Methodology with a heatmap of a broad set of indicators. Yet, the experience of recent exogenous shocks to the economy illustrates the difficulty of implementing such an approach. With continued use of the structural balance in the domestic fiscal framework, developing a national measure of the output gap as many other countries have done, subject to the oversight of the Fiscal Council, may help to provide better guidance about the state of the economy.
Strengthening the resources and analytical capacity of the Fiscal Council would help to inform the domestic policy debate about the fiscal path and rules. The current remit of the Council includes assessment of the macroeconomic and fiscal forecasts of the government, as well as compliance with the fiscal rules. Unlike some other fiscal councils, it does not perform analysis of long-term fiscal sustainability beyond the government approved medium-term framework. The board of the Council is composed of six members, nominated for five years upon a proposal of the governor of the central bank. In 2020, the Council’s budget was EUR 80 000 and employed three analysts, similar to that of Latvia and other small countries but lower than in many other countries (OECD, 2021c). This constrains its ability to undertake analysis that would allow the Council to play a more effective role in the fiscal policy debate. The OECD Principles for Independent Fiscal Institutions highlight the need for sufficient financial resources to ensure satisfactory performance of its tasks (OECD, 2014).
The planned tax and benefit changes for 2024 and 2025 are regressive, although transfers and the minimum wage have increased in recent years (Figure 2.10). The main VAT rate has increased by 2 percentage points this year. In 2025, a reform will raise the personal income tax by 2 percentage points and alter the basic tax allowance. Under the current system, personal income is taxed at 20% with a basic tax allowance of around EUR 8 000 phased out one-for-one between EUR 14-25 000 (average annual income is just under EUR 22 000). From 2025, the tax allowance will be applicable to all incomes without any phasing out. While this removes the high marginal tax on middle incomes and raises the rate, the change is regressive because the basic allowance is extended to people with the high incomes. At the same time, it reduces personal income tax revenues. The combined impact of these tax and benefit changes on lower income households is only partly offset by the higher minimum wage.
Tax and benefit simulation model (Euromod) of 2024-25 tax and benefit changes
Note: The model is static and does not include possible behavioural and other dynamic effects. Measures include VAT, excise and partial land tax increases and PIT changes, as well as changes in child benefits.
Source: Ministry of Finance (2023).
The overall labour tax burden is expected to fall by 1 percentage point as of this year (Ministry of Finance, 2023). The authorities’ estimates suggest that these tax changes could increase poverty, putting at risk the progress made in recent years. Increases in subsistence benefits, which could party offset this impact, are planned, although the details have not yet been specified. Over time, moving away from a personal income tax with a flat rate towards a progressive rate schedule used in the vast majority of OECD countries would allow the tax system to raise revenues in a more equitable way. To this end, the authorities could set up an ad hoc tax commission or review including outside experts that would look at the overall incidence of the current taxes and explore avenues for introducing more progressivity, for instance by applying a higher tax rate for higher incomes, introducing taxes on immovable property and inheritance taxes, as recommended in previous Surveys. Such commissions have been used for instance in Australia, Ireland and Norway. A recent report by the Foresight Center, a think‑tank under the Parliament, has outlined several possible scenarios for raising revenues in an ageing society with an increasing role of digitalisation and green transition (Foresight Centre, 2021).
Note: AW – average wage. Data refer to single person without dependents.
Source: OECD Tax Database.
The general government gross debt ratio was the lowest in the OECD at 19.6% of GDP last year. The share of government revenue in GDP was 33% in 2022, slightly below the OECD average of 34%. Favorable debt dynamics imply that following the government’s fiscal target of a structural deficit of up to 1% of GDP would see the debt ratio rising only modestly over the coming decades (Figure 2.12). However, there are long-term fiscal pressures due to population ageing, climate change, defense spending and other factors.
The pension system is based on three pillars with a first pillar composed of a basic and earnings-related pay-as-you-go scheme, a second pillar based on a funded defined-contribution system and a third voluntary pillar. The current contribution rate to the public pillar is 16% and 6% for the second pillar, where the employee contributes 2% and the state 4% from a social tax paid by the employer. As of 2025, participants in the second pillar will be able to raise their contribution rate to 4% or 6%. For those who do not take part in the defined contribution pension, the contribution rate to the PAYG is 20%. Over time, the relative value (the replacement rate) of the first-pillar pensions is set to decline, reducing fiscal costs. However, the current and future adequacy of the first pillar public pensions is low. The future net replacement rate from the public pillar stands at around 34% for a worker earning an average wage, one of the lowest in the OECD. Old-age poverty remains an issue: 35% of people over 65 have incomes below half of the median equivalised household disposable income, the third highest share among OECD countries (OECD, 2023h). For the future, there is uncertainty about whether people’s savings in the other pillars will be sufficient to support a decent income in retirement, but recent withdrawals make this less likely. This gap could ultimately lead to pressures on the public finances from the low incomes that many pensioners are likely to face.
Recent policy reforms have both strengthened and undermined pensions sustainability. The current retirement age of 64.5 years is increasing to 65 by 2026 and will thereafter be linked to developments in life-expectancy (with a partial indexation capped at 3 months per year), which will improve the sustainability of the public pension system as the population ages. However, in 2021, Estonia followed some other central and eastern Europe countries in abolishing the obligation to participate in the funded scheme. This is expected to have a negative impact on future pension adequacy for those opting out: over a third of participants have left already, often those with low income and who were credit constrained (ERR, 2023). This increases the risk that the state may need to help these people in future years. The authorities are currently exploring options for introducing an occupational pensions scheme.
Population ageing will bring additional fiscal pressures, both in terms of rising costs and falling tax revenue from labour (Figure 2.12). In particular, government healthcare expenditures are set to rise from 5.4% of GDP in 2022 to 6.8% of GDP in 2060 even if the increase is among the lowest in the OECD (EC, 2021). As set out in Chapter 5, health outcomes could be improved by a package of reforms, including efficiency saving, additional spending to increase the renumeration of doctors and nurses and boosting training to reduce staff shortages.
Note: In Panel A the “Current tax and spending policies” scenario assumes that the structural primary fiscal balance before accounting for ageing-related costs remains constant at 2025 levels and the balance declines with rising ageing costs and interest expenditure. The “Path assuming a medium-term objective of -1% and offsetting ageing costs” scenario assumes that the underlying primary structural balance of -1% of GDP is achieved in 2026 and is held constant thereafter. The “Implementing structural reforms” scenario adds to the scenario with achieving medium-term objective of -1% implementation of the package of structural reforms reported in Table 1.1 in Chapter 1. In Panel B, the change corresponds to the path under fiscal rules with medium-term objective of -1%, offsetting ageing costs and with structural reforms (green line in Panel A). The net ageing costs are defined as changes in expenditure on old-age pension, health and long-term care minus changes in expenditure on education.
Source: OECD calculations based on OECD Economic Outlook database and OECD Long-Term Model.
Reducing net GHG emissions of the economy to zero requires significant investments of around 4% of GDP during 2021-30, and 2% of GDP annually by 2040 (SEI, 2019). While the private sector is expected to undertake three quarters of the investment, public sector investment in energy, transport infrastructure that enables decarbonisation, and upgrades of public sector buildings is estimated at 0.5% of GDP annually (SEI, 2019) (Chapter 4).
Taking rising ageing and health costs alone, current tax and spending settings would imply a modest increase in the debt ratio in the years ahead, albeit likely remaining lower than most other OECD countries (Figure 2.12, Panel A). Complying with the existing fiscal rule with a structural deficit of 1% would result in debt ratio rising to 35% of GDP in 2040. This is estimated to require fiscal consolidation of around 0.4% of GDP over the coming years and some additional savings or tax increases over the medium-run to offset the rising costs of ageing (Figure 2.12, Panel B). A package of measures proposed in this Survey to boost growth and improve health outcomes (Table 1.1), together with an illustrative set of measures achieve the necessary fiscal consolidation in Table 2.8. This consolidation requirement could be struck in different ways using other combinations of tax and spending policies, although spending pressures and the ambition to improve health outcomes would necessitate reallocation of spending from other areas or higher taxes.
Illustrative estimates, no second-round effects
Notes: 1. Based on the assumption that the property tax will be in the same magnitude as in the average OECD country in terms of ratio to GDP. 2. OECD (2022) Economic Survey of Estonia, based on estimates of the Ministry of Finance of Estonia.
Source: OECD calculations.
While many of the consolidation measures identified by the government so far were on the revenue side, spending reviews by line ministries are being undertaken with a view to identify areas to reduce spending. There is a separate review of existing social benefits that aims to introduce more means testing, which is welcome. Family benefits increased significantly prior to the pandemic. The parental benefit, linked to wages, is capped at triple of the average wage, but child benefits (EUR 80 month per child for the first two and EUR 100 month from 3rd child onwards) and those for large families are universal (Annex A.1). The parental benefit is comparatively generous, as it provides one of the longest full-rate equivalent paid leave periods among OECD countries (OECD, 2021b). These policies, aimed at increasing the birth rate, as well as reducing child poverty, merit review (OECD, 2021b). Overall, Estonia spends around 3% of GDP on family benefits, three quarters in the form of cash benefits. As recent analysis of OECD countries illustrates, labour market outcomes, as well as family policies, are important factors influencing fertility (Fluchtmann et al, 2023). Targeted childcare benefits can increase the amount of support for people on lower incomes without the cost of paying them to those with higher incomes. Any reform of these benefits should avoid withdrawing means-tested benefits too quickly as incomes rise to avoid creating disincentives to taking on additional hours of work.
The size of the government in Estonia is slightly below the OECD average, suggesting some scope to raise additional revenues. The tax system is based on a flat-rate income tax with little progressivity, significant VAT rates and a corporate tax only on distributed earnings (Figure 2.13, Panel A). There are relatively few tax expenditures in this system, estimated to amount to only around 1% of GDP (Ministry of Finance, 2023a). Elimination of various fuel tax exemptions would bring additional revenue of 0.1% of GDP and additional revenues could be raised from the carbon tax (see Chapter 4). Any increase in tax revenues should include raising property taxation. Recurrent taxes on immovable property taxes are considered economically efficient and the least damaging taxes to long-run economic growth (OECD, 2022c; Johansson 2016; Cournede et al, 2018). Advanced OECD countries tend to rely more on immovable property taxation (OECD, 2022c). For example, in the United States, Canada or the United Kingdom, housing taxation accounts for 8% of tax revenues (Figure 2.13).
Estonia collects property tax revenues of 0.2% of GDP in the form of a land tax and there is no tax on immovable property. A number of exceptions to the land tax are in place, such as for land plots where a principal residence is located (of up to 0.15 hectares in residential areas and up to 2 hectares elsewhere). This year, an updated land valuation will be applied for the first time since 2001 and an automatic upgrade of the land valuation is scheduled every four years. Although the land value has increased on average 8 times since 2001, it will be phased in gradually and municipalities will now have the right to exempt primary residencies. Moreover, it is no longer possible to deduct mortgage interest rate costs. The revenues from the land tax are fully assigned to the municipalities, which can also set the rate within a given bracket (between 0.1% to 2.5% of taxable values). Most municipalities have so far opted to tax at the highest rate allowed (OECD, 2022c). Lifting the limits on the rate would give municipalities larger revenue-raising autonomy. Once the land tax revaluation has been phased in, an introduction of a tax on immovable property should be considered. The tax should be carefully designed and implemented to avoid unfavorable impacts on lower-income households. To avoid the ‘home-rich, income-poor’ phenomenon and improve the political acceptability of such reforms, deferral mechanism could be introduced, as done for instance in Denmark (Box 2.3).
Source: OECD Tax Database.
Reforms of housing taxes have traditionally been met with public resistance (OECD, 2022c). One of the frequent policy issues has been how to avoid unintended effects on low-income households who, as a result of such reform, can find themselves with housing wealth but little means to pay the tax, especially in areas that experienced considerable increases in valuation (the so-called ‘house-rich, income poor’ phenomenon). To address such issues and improve public acceptability, several measures can be included:
To alleviate liquidity issues, allow for tax payments in instalments, third-party remittance and/or tax deferral (e.g., until when the house is sold or transferred). Typically, only certain taxpayers are eligible for tax deferrals, such as low-income or senior taxpayers. Countries that use tax deferrals include Canada, Denmark, Ireland and United States.
To increase income progressivity, a flat amount of tax relief or a cap on tax liabilities to low income low-wealth households can be part of the reform.
Bundling the reform with other tax changes (e.g., reduction in transaction or labour taxes).
Improvement in local public services, proactive dissemination of information on how the new tax revenues will be spent.
Higher tax rates on secondary residences.
Source: OECD (2022c), Housing taxes in OECD countries.