The Ministry of Finance provided sides to Estonia's ongoing coalition negotiations (Reform, Eesti 200, SDE) with an overview of the fiscal situation on Wednesday. The overview was made available to the press on Thursday and holds little in the way of encouragement.

The Estonian state budget sports a hefty deficit, with expenses coming to €17 billion and income to €16 billion this year, which situation is not bound to change without action. The current government puts the deficit at 2.6 percent of GDP also for the coming years.

Economic growth and additional revenue are not expected to improve the situation. Sven Kirsipuu, deputy secretary general for monetary policy, gave the example of €606 million in additional revenue used to cover automatically bigger expenses during a previous fiscal year. Only €67 million of the extra revenue could be used freely, so to speak.

Economic growth automatically results in new expenses in the fields of social policy, national defense and R&D. While Estonia can afford to finance a deficit of 2.6 percent of GDP, the ministry finds this to be unsustainable and in violation of EU fiscal requirements that will enter back into force from next year.

Kirsipiuu said that improving Estonia's fiscal position by €750 million by 2026 requires a colossal amount of money in budget terms. "If a few years before Covid, coalition talks honed in on millions, we are talking about hundreds of millions today," the undersecretary remarked.

More so as the coronavirus crisis and the Ukraine war have kept the Riigikogu from passing a budget in accordance with fiscal rules for years. Raoul Lättemäe, head of the ministry's fiscal policy department, said that the outgoing Riigikogu has passed just one regular budget.

What would be the incoming coalition's options? Broadly speaking, there are two ways of improving fiscal position. Estonia can either hike taxes or cut public spending.

Both the Reform Party and Eesti 200 have talked about the need for cuts since elections. The Social Democrats have plotted a more cautious course so far.

Kirsipuu said that it is possible to cut costs, increase public sector efficiency or dial back public service quality. He said it is a matter of political choice how much of what Estonia will do. "Not all services must be offered on the highest quality level, it may be a political choice," he suggested.

Kirsipuu added that austerity cannot free up major sums. A recent public sector cutback saw the orchestras of law enforcement organs liquidated. "It may prove impossible to find hundreds of millions by cutting costs," he suggested. Many public institutions need additional funding instead.

Estonia's public spending is modest when compared to the rest of Europe – both generally and when looked at by field. The only sectors where Estonia has high public spending are education, leisure time, culture and religion, and national defense. That said, considering the incoming rulers' wishes to boost education funding, reluctance to close small rural schools or theaters and plan to maintain current level of national defense spending, those areas are likely safe.

We are left with tax hikes. Estonia sports a low tax burden compared to the rest of Europe. The country took in €4.5 billion in social tax, €3.3 billion in VAT, €1.3 billion in income tax and €1 billion in excise duty revenue last year. Revenue from other taxes is considerably more modest. Having to cut €750 million annually is a daunting task in this context.

Only the Social Democratic Party (SDE) promised to hike taxes before elections. Their program proposed hiking income tax (by introducing a so-called national defense tax component), switching to progressive income tax and collecting social tax on dividends. The other parties currently engaged in coalition negotiations rather talked about hiking the basic exemption for the wealthy.

Slashing income tax in such a way would constitute moving away from the goal of fiscal balance to the tune of €470 million the first year and €360 million during consecutive years, the ministry's calculations found, creating an even bigger need to hike other taxes.

Kirsipuu said that while all tax hikes theoretically work to slow down economic growth, the effect is smaller in the case of some. Capital taxes have the biggest impact on growth, next come labor taxes, then consumption taxes and finally property taxes, which have the smallest impact.

The undersecretary added that property and transport taxes are virtually nonexistent in Estonia when compared to Europe. Land tax has not been hiked for years, with land under people's homes also mostly tax free. Estonia also has virtually no vehicle taxes.

The ministry estimates that such taxes could be used to collect up to €100 million annually. Provider there is political will to introduce such taxes. It is also possible to design other taxes or hike existing rates, as per the Social Democrats' proposal.

In summary, Kirsipuu suggests that a single measure is not enough to return to fiscal balance. Several things would have to be done simultaneously. Boost revenue from several taxes and seek efficiency in certain things, or cut public sector costs in other words.

Theoretically, it is also possible to just keep borrowing to cover the deficit. Estonia should be fine in the short perspective if nominal deficit is kept under 3 percent of GDP. This would require amending the State Budget Act and borrowing. Estonia would also have to hope European fiscal balance rules will be changed. That said, continuing to rely on loan money for fixed costs would see the country's loan burden continue to grow and annual interest payments make up an increasing part of state budget expenses.

Borrowing €750 million at a rate of 4 percent would cost €30 million. Provided no changes are made, Estonia will have to pay €464 million in annual interest on the forecast loan burden of €11.6 billion by 2026.

Kirsipuu said that trying to borrow one's way to wealth would be a risky goal. He gave the example of Greece the standard of living of which was nearing the EU average on the back of loan money before everything collapsed and the country fell back into poverty.

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