State finances and economic policy

Estonia's governments have usually pursued balanced budgets, so the state budget has been more or less in balance, and at times there have even been budget surpluses. Budget reserves produced by surpluses enabled the Estonian government to avoid borrowing during the crisis, and because of that its debt burden is among the lowest in Europe: only 6.2% of GDP. About half of these loans have been taken out by the central government, with the lenders being the World Bank, the European Development Bank and the European Investment Bank. In 1996, the government borrowed from the World Bank, in 2000 from the European Development Bank, and in 2009 from the European Investment Bank. The Republic of Estonia holds no bonds.

​In the period of economic decline in 2009, the government was forced to raise taxes and cut spending to control the deficit. As a result, the budget deficit was very small compared to the rest of Europe, about 2% of GDP. Thus, Estonia doesn’t have the same kinds of problems that haunt most of the countries of the European Union and the euro zone.

​Estonian governments have had quite similar economic policies, no matter the composition of the government. Of course, different parties don’t always have the same approaches to taxes and social policies. But Estonia has always had coalition governments and so the governing parties are impelled to find compromises. Estonian economic policy can mainly be characterized as right-wing, although there have been left-wing parties in ruling coalitions (e.g. Social Democrats). This is the reason why the government’s economic policy has been mostly friendly to entrepreneurs and investors and, with small exceptions, has maintained low taxes. The state hasn’t had enough money to establish a really generous social welfare system. Spending has continuously been examined and effectiveness increased, because the circumstances have forced it. Money from different structural funds of the European Union has been quite important to Estonia, especially during the economic crisis, and Estonia has been one of the most successful countries in making use of those funds.

For hard times the state has accumulated the budget surplus and revenue obtained from privatisation into a special Stabilisation Reserve which can be used in specific cases by a resolution of the Riigikogu and for carrying out important long-term reforms (e.g. pension reform). The volume of the fund has increased to about 325 million euros. In addition, the central government has other funds and reserves (at the end of September 2011, about 612 million euros).

The government’s policy during the crisis
Although Estonian governments have mostly tried to maintain budget surpluses, the economic crisis that began in 2008 turned out to be so extreme that, despite cutting spending, the budget went into deficit. Because of decisive action, the deficit was limited: in 2008 the deficit was just under 3% of GDP and in 2009 2% of GDP. By 2010, the Estonian state budget had a surplus again (0.3% of GDP).

​What did the Estonian government do? Budget cuts began in mid-2008 and, in February, May and June 2009, more extensive cuts were needed, because economic growth turned out to be much worse than forecast. Although the Republic of Estonia had reserves, there was fear that these might run out if the economic crisis continued. Borrowing was not considered possible at the end of 2008 and the beginning of 2009, because Latvia's problems hinted that the same would happen in Estonia. The decline in the state budget in 2008 was 3.1 billion kroons (198 million euros), which was 1.2% of GDP. The decline in the state budget in 2009 was 16.1 billion kroons (1.03 billion euros), about 7.4 of GDP. The process of cutting the budget was complicated and, because of differences of opinion between parties, the Social Democrats left the ruling coalition. Although the ruling coalition did not hold a majority in the Riigikogu, the changes were passed.

​Spending was cut and tax revenue was increased. The operating costs of public establishments and establishments that received money from the state budget were decreased, including salaries (7% in February 2009 and 8% in May); teachers, policemen and culture workers were handled a bit more gently. The cuts in salaries included the right of every establishment to decide how wages would be decreased: through layoffs, general reduction in all salaries or unpaid vacations. In most cases, all those measures were taken. Increases in pension were cut (with later compensation), defense expenses were cut, the costs of road management were cut and many less important activities were curtailed. Cuts involved health care, too, as well as the compensations that the new Employment Contract Act (in effect since the middle of 2009) had originally budgeted for unemployed people. In the middle of 2009, the health benefits paid from the Health Insurance Fund decreased and companies started paying partial benefits. In June, the state’s payments for the second pillar of pensions ended (these will be restored in December 2012).

​In the first half of 2009, a rise in many taxes was decided upon. The value-added tax rate was increased from 18% to 20% and many benefits were eliminated. The rates for unemployment insurance contributions by workers were raised twice: to the allowed maximum of that time (3%; see Tax system) in June and to a temporary 4.2% in July. Now the government is arguing with enterprises and labor unions about lowering this rate. Excise taxes on fuel, tobacco and natural gas were raised; the first two were even raised twice. The state started selling its unnecessary property: buildings and land. Among other things, the state's share of Eesti Telekom was sold and the trading of emission allowances began. Restrictions were placed on local governments taking out loans, and they were allowed to do so only to co-finance the usage of structural funds from the European Union, with the agreement of the central government.

​Changes in the state’s finances involved more than cuts and raised taxes. In many fields, costs increased because of required expenditures (e.g. unemployment insurance and social benefits), as well as efforts to support the economy. An effort was made to increase access to European Union funds and, as a result, the application process and usage of these funds was simplified. Also, money was distributed to support investments by companies, exports and to train unemployed people. Changes in state administration and legislation that supported business activities and expanded the economy became the priority.

​Such severe cuts wouldn’t have been possible without the understanding and agreement of the citizens of Estonia. Because of that, especially at the beginning of 2009, the government made a major effort to explain why government spending and wages should be cut and taxes raised. It helped that cuts in salaries had already begun in the private sector. It was also important that, in both the private and public sectors, decreasing labor costs didn’t mean (at least generally) layoffs. It may be that Estonians found it easier to accept the hard times because they had enjoyed the good life for only a few years, and the even harder transitional years of the 1990s were still remembered.

​Now, the government is gradually beginning to alleviate the austerity measures: the state’s payments to the second pillar of the pension have resumed and, through the budget cuts, expenses in the public sector have decreased.

Tax system
The Estonian government gets the majority of its revenue from taxes (83% in 2010). Estonia's tax burden is often said to be low but this is the case in comparison with the Nordic countries. In comparison with the salaries, taxes relating to the workforce (personal income tax, social tax, unemployment insurance tax) are among the highest in Europe. The excise and value added tax revenue in relation to the volume of economy is very high by European standards. Estonian property taxes are modest compared to the rest of Europe because the overall tax burden on the economy is relatively low.

The most important taxes for the state are social tax, value added tax, personal and corporate income tax and various excises. During the last few years very modest revenue has been generated by customs duties.

Value added tax
The regular value added tax rate in Estonia is 20%, in some cases lower (9%) or does not exist at all. In principle, value added tax in Estonia resembles that of the European Union – minimum rates are uniform with very few exceptions.

Excises
In Estonia, excises apply to tobacco, alcohol, fuel, electricity, natural gas and packaging. The majority of the excise rates already correspond to EU minimum rates. Compared to Europe and especially to Scandinavia, Estonia has established several lower excises primarily due to the poverty of the population – a rise in excise rates always tends to increase the volume of the black market. As excises are determined as monetary value and not as percentages, the relative level of excise rates is higher for an Estonian citizen compared with other countries.

Social Taxes
Estonia has established a social tax, which is divided into two – 20% goes to the social fund for the pensions of the present pensioners (16% in the case of those who opted for compulsory pension insurance) and 13% to health insurance to finance the Estonian health care system. Those sums cover both medical treatment expenses and health insurance benefits. Estonia has also established an unemployment insurance for which a person pays 2.8% of the salary and the employer pays 1.4%.

Personal income tax
Estonia has a uniform income tax rate of 21%. Deductions can be made of the taxable amount – first the basic exemption, then insurance premiums paid pursuant to a pension insurance contract, housing loan interest etc. The current government wants to decrease the overall income tax rate to 20%. A part of the income tax of private individuals goes into the state’s budget and another part to local governments.

Corporate income tax
In Estonia the rate of the corporate income tax is 21%, but the tax is imposed solely on the amounts collected as profits by the owners (e.g. dividends). Thus the reinvested profits are not subject to income tax.

​​Property tax
The land tax is the most important property tax in Estonia; most land owners pay it. The land tax is profitable for local government. Beginning in 2013, a certain portion of residential land will be tax exempt. In Estonia, there’s no general automobile tax but there are heavy vehicle fees.

State Expenditure
The majority of the state expenditure is incurred in the social sphere – for health care, pensions and other benefits as well as for education. State expenditure is modest regarding the support of private companies; in general, subsidies have been paid to agriculture in the case of unusual environmental conditions. Companies have received state aid indirectly – through public procurement contracts. The state has invested primarily into road construction and environmental protection, sometimes through loans. Since 2004, the state has distributed EU funds to ventures, to increase competitiveness, technological development and innovation. Many grants involve contracting with private companies to perform work, for example in supporting local economic and social development or energy-saving programs. The percentage of military expenditure is under 2% of the GDP which has been the requirement for the Estonian membership in the NATO.

Local Governments
There are 226 local governments, including 33 towns, in Estonia and the majority of them are small and poor. Budgetary revenue of the local governments consists of a percentage of personal income tax (more than a half), land tax, tax on natural resources, some local taxes and, to a great extent, allowances from the state budget. The state allocates funds to the local governments for the performance of some state functions (e.g. for schools of general education, road maintenance, social welfare).

In Estonia, the financial state of the local governments is significantly worse than the state as a whole – on the one hand, small local governments lack major income, especially when the local population is aged and there are no jobs. On the other hand the expenses are quite big even in small local governments. Often there is no money left after the basic needs have been met and thus numerous local governments have taken on loans to renovate heating systems or mend roads. During the economic crisis, serious restrictions were placed on local governments’ borrowing and that’s why their budgetary situation has improved now, although many still basically go bankrupt.

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