President's economic advisor: Estonia's spending out of hand

Kaspar Oja.
Kaspar Oja. Source: Bank of Estonia

Economic adviser to the president Kaspar Oja tells ERR in an interview that past campaigns to introduce new expenses are putting strain on Estonia's state budget.

Oja sees the Family Benefits Act bill currently in Riigikogu proceedings as belonging to that list and says that recent governments have spent so much even when times are good to have left the budget in constant deficit.

While considerable EU subsidies have helped cover costs, they will increasingly fall off as Estonia becomes wealthier. Therefore, Estonia will soon have to dial back spending or hike taxes. Oja recommends against temporary motor fuel excise duty or VAT on food cuts.

Minister of Finance Keit Pentus-Rosimannus (Reform Party) and some analysts suggest we cannot lower excise duties or pump new money into the economy as it would fuel inflation. However, the situation is not one of economic overheating where people and companies have a lot of liquid assets. What we have is a major war in Ukraine and broken supply chains that has resulted in rapid price advance…

We are still overheating in some ways. Polls suggest that companies find the situation late last year similar to 2006-2007. Looking at retail trade, turnovers have exploded. People are still spending a lot of money after dialing back during the coronavirus period. The dismantling of the second pension pillar (making funded pensions voluntary and allowing people to withdraw assets – ed.) also gave some households access to additional funds. We have seen plenty of consumption-based growth recently.

I would draw a parallel from the past. The situation today resembles the 1970s. After the Arab-Israeli war, oil producers sanctioned countries that had supported Israel. Oil suddenly became very expensive in the West and inflation skyrocketed. The initial reaction was what has been suggested now. Policies were relaxed in hopes it could prop up the rest of the economy and avoid a crisis.

The result was even faster inflation that got completely out of control in subsequent crisis waves. Draconian monetary policy was in order to stave off the worst, with the U.S. introducing interest rates in the double figures. The faster our reaction to inflation sliding out of control, the less strict we will have to be at the end of the day.

This brings me to my next question of why not raise VAT in a situation where we need to contain consumption?

Some economists have suggested doing just that. But we need to consider the political reality – I don't see it as particularly realistic. A short-term VAT hike would also add to inflation.

It needs to be kept in mind that benefits are always redistribution. Normally, the government has fiscal constraints, that income and expenses should be more or less balanced. This means that hiking benefits would require money to be taken away from somewhere else. However, fiscal constraints have become loose as not to say out of hand today.

Proposals to hike expenses usually forget to mention ways of covering rising costs. This has been the trend lately in Estonia, and we have created expenses for which there is no cover. The state budget stays in the red even when times are good as tax revenue is no longer enough to pay for government spending.

We need to keep in mind that Estonia is receiving European subsidies to the tune of 2 percent of GDP today, while our standard of living quickly catching up to the European average means these sums will fall abruptly in the future.

This means the budget will have even more expenses for which no cover exists, and we have to start thinking of ways to remedy the situation.

Is the proposal to hike family benefits currently in Riigikogu proceedings one such example?

In a way. While it has been suggested it could be paid for using additional tax revenue, the budget is already in deficit. Additional tax receipt is the result of rapid inflation, while it also hikes the government's expenses. Inflation and extraordinary tax receipt are not good ways to pay for such long-term things.

The Riigikogu recently passed Estonia's largest ever supplementary state budget (almost €900 million – ed.) used to pay for unexpected expenses. No steps to review other expenditure were even discussed. Do these new circumstances mean Estonia should go over its expenses?

The reality of the situation is that half of 2022 is behind us and we would need to consider how realistically we could reshuffle coming months' expenses. We are heading into state budget strategy deliberations to lay down the coming years' expenses in late summer.

It is true that price advance makes it sensible to postpone or cancel some investments. And it is being done as projects have become so much more expensive. Contractors might not even be able to realize projects as there are acute material shortages.

However, we do not need a major and fundamental budget reform just yet. The goal of the supplementary budget was to allocate more funds for specific fields. For example, national defense, refugees and energy security. We need to make sure to avoid extra spending and keep to the budget concerning the rest as every new expense adds to price pressure and inflation.

Let us return to temporary support measures. Why are other countries slashing taxes? For example, Germany will be lowering taxes on gasoline by 35.2 cents per liter. Finland and Latvia are reducing the mandatory biocomponent content in motor fuels to bring the price down. But we are told that ours is a small and open economy and that it would have no effect…

A 10-cent excise duty slash on motor fuel would bring the price down by approximately 5 percent for an inflation effect of 0.3 percent. While the move would cost the government far more than the planned subsistence benefit hike. It just does not appear proportional.

The effect on people's expenses would be minute in either case, while it would be considerable for the state budget. We could rather use the money elsewhere, fields that really need help. Some who buy motor fuel also need support more than others. But universal benefits have little effect.

The price cuts in Europe are aimed as temporary measures in hopes that the world market price of oil will return to its recent level, while that seems too optimistic on the backdrop of the last few months' developments.

We already know that energy prices will set new records in the coming fall and that we will need support schemes. The information today is that this will once again be done in one sweeping motion, irrespective of individual needs. Could we have more sophisticated support models by fall? For example, an IT engineer making €4,000 a month will be okay without a transmission fee cut.

Talking to colleagues from ministries, there seem to be some preparations or ideas at least. We cannot say officials are sitting idly. But income-dependent instruments also have their pros and cons.

We must keep in mind that energy prices are forecast to remain high for several winters to come, which is why we are not really talking about temporary measures. Prices will only come down once plans to adopt new energy sources are realized and those capacities come online.

Any measure that depends on the recipient's income runs the risk of distorting the economy. People could decide not to work overtime for fear of not qualifying for support. It might pay for others to go on unpaid leave to qualify for benefits. Custom and targeted measures are good in the short term, while they make less sense over longer periods. It is likely we will have to look at international experience.

Conservative People's Party (EKRE) leader Martin Helme said on the "Otse uudistemajast" webcast that Estonia could slash VAT on food to 5 percent for the forecast price advance period. What is your take on the idea?

The problem with that is the same as with excise duty cuts. The measure itself is probably hugely expensive, while we could help those who need it in other ways. I once attended a lecture by Nobel Prize winner James Mirrlees on the problem in developing countries. He said that high food prices must not be addresses through tax cuts but benefits for the low-paid part of the population. Mirrlees argued that food should have been taxed more. While I don't agree with the latter, slashing taxes would not constitute a well-aimed measure.

Looking at the big picture, Europe has got food covered. We have the common agricultural policy and robust food security. However, a sharp decline in food production in Ukraine is bound to have an effect on poorer states. In Africa, for example. Lowering taxes in Europe would boost demand for food products that would lead to famine in Africa, followed by another wave of migrants. We don't want that.

And it is in this difficult situation we are headed for Riigikogu elections next March. Politicians will want to be more generous than they can afford to be. We are sure to see promises to slash excise duties while hiking benefits, with Estonia's low tax burden given as the source for all the extra spending. Are you concerned?

I am. The current debate over family and child benefits is a manifestation of this tendency. I would be very happy were every promise complemented by how we plan to pay for it. Whether by hiking taxes or taking something away from someone else.

We will have to answer that question eventually. While we can pile up deficit and loan burden, it will run away from us at one point. Government loans have become more expensive in recent months and interest rates keep rising. This level of borrowing will become too much for us eventually, which is when we will have very little time to find ways of covering expenses. Past experience suggests this process could be highly unpleasant.

Many say that we need to borrow because inflation makes it easier to make loan payments. You do not believe that Estonia should have borrowed more during years of negative interest rates to fix things up?

We have received a lot of money from Europe. In other words, the sums have been borrowed by other European countries that have paid more into the EU budget. That borrowing has taken place on the European level and we have benefited through European subsidies. But our standard of living has hit 90 percent of the EU average, meaning that we are looking at much more modest support in the future. Our standard of living is already ahead of many older EU member states and will continue to grow should things go well.

Therefore, we do need an audit of state expenses and revenue to meet difficult times with confidence?

It is a matter of the state budget strategy. We need a longer view for how to balance the government budget in the coming years. It would also answer the question of the sustainability of the current budget. The tax debate will arrive with elections, which is where we will have to decide whether to spend more and hike taxes or spend less and leave taxes untouched.

That will not happen during campaigning! We will simply be promised new spending, while no one will dare broach the subject of tax hikes.

Unfortunately, it is true that politicians are reluctant to discuss the latter. On the other hand, looking at the state budget, while there have been attempts to hold back spending, working campaigns have introduced permanent costs.

Incentives for a certain group in society require money to be pulled from somewhere, while recent experience suggests public sector salaries are often that place; for example, those of teachers, rescuers or police officers. These are services that the public sector must offer, and not being able to do that would be a major problem.


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Editor: Marcus Turovski

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