Egert Juuse: Euribor as a private sector tax
The astronomical profits of Estonia's mostly foreign-owned banks are just the tip of the iceberg as their combined retained profits amount to 7.2 percent of GDP. What in this context justifies banks' 14-percent income tax rate compared to the ordinary citizen's standard 20-percent rate on (nearly nonexistent) deposit returns, Egert Juuse asks.
Estonia has served as an example for the rest of the world through many a success story. Who doesn't like topping international indexes, whether we're talking about Estonia's ninth place in the digital economy and society index, fourth in terms of human freedom or first place for the ninth consecutive year in the OECD tax competitiveness ranking. In February this year, many also learned that people in Estonia know how to do business and then some, even though this has been a self-fulfilling prophecy in light of global financial developments of the past year.
We are talking about the record profits of commercial banks active in Estonia from last year, which sparked comments from representatives of constitutional institutions. Even though the Bank of Estonia added the item to its agenda, it never shaped a position, despite the FSA admitting that banks' profits seem to have come out of nowhere. The prime minister parried the question by praising the virtues of a stable economic environment.
However, the 2022 profits of banks are just the tip of the iceberg in an almost literal sense. What has been overlooked or makes for a reluctant topic of conversation is the ticking time bomb of "retained profits from previous periods" in banks' balance sheets, which as of January 31, 2023, amounted to 7.2 percent of the Estonian GDP. Sitting on this ever-growing pile of cash are mostly foreign-owned banks, with 85 percent belonging to the two leading credit institutions.
Banking sector profits in perspective
This figure needs to be put in perspective to get a better idea of the magnitude in GDP, which Estonians tend to fetishize. The retained profits of the food and machinery sectors amounted to 2.2 and 1 percent of GDP respectively in 2021. Around 1,500 companies were active in the two sectors. We can compare this to 6.6 percent of GDP and around a dozen players in banking.
Talking numbers, we should hark back to the goal of spending 1 percent of GDP on research and development, which goal remained elusive for years and has by now culminated in universities' refusal to sign new public law contracts [for funding] with the Ministry of Education and Research. If we add the private sector, R&D funding has only amounted to 1.75 percent of GDP even during the best years of the last decade, which is far behind the OECD and EU averages.
The situation has been somewhat better concerning defense spending, which has been maintained at 2 percent of GDP since 2015. We can also pound our chest after giving Ukraine military aid worth 1 percent of GDP, which puts us on top in the world. However, all of it pales in comparison to the retained profits of banks, which begs the question of the value the banking sector adds to the Estonian economy, compared to the processing industry, R&D or defense to warrant this level of profitability.
Experimentation in finance as a fertilizer for growth
It is true that credit institutions' shrewd business activity has contributed to solid profits. Looking at major financial aptitude indicators, such as return on assets (ROA) or return on equity (ROE), the Estonian banking sector handily outperformed its counterparts in Finland, Latvia, Lithuania or Germany in 2000-2021.* However, "experiments" conducted by Estonia and the European Central Bank have played an equally significant role.
The foundation on which banks' profitability in Estonia rests has been laid over decades, starting with the 1992 currency board system, which has not been used much elsewhere in the world and virtually removed currency risks for banks in Estonia during the Eesti kroon period, and followed by Estonia's unprecedented corporate profits tax reform in 2000. The taxation aspect culminated in 2018 with amendments that prescribed a lower 14-percent income tax rate, with banking the only sector in Estonia that enjoys such an exception.
Still, this was just foreplay – the flood gates were really opened by the European Central Bank in the middle of last year when it hiked the Euribor rate in an attempt to contain inflation. The situation was unprecedented – the average inflation of the 20-member Eurozone was 8.38 percent, compared to just 1.66 percent in 1999-2021. The euro was used by 12 Member States in the early 2000s. We can say in light of recent developments that the ECB's move, which is forecast to continue, was also unprecedented. This presents two problems, from Estonia's perspective and beyond.
Shot and miss?
On the one hand (based on economic theory), interest rates should be hiked if the economy is overheating – when resources are fully utilized, while supply cannot meet demand in the conditions of additional money supply. However, analysts have pointed to supply chain disruptions and problems sourcing production input due to the coronavirus and geopolitical developments, which are rather challenges on the supply side of things, instead of excess demand.
Common sense suggests that hiking Euribor to make loan money more expensive in such a situation in no way contributes to solving said bottlenecks, one example of which could be investments in reorganizing value chains. The complexity of Euribor manipulation is also reflected in events unfolding in the United States where local banks struggling has been partially attributed to the Federal Reserve System's rate hikes. One cannot help but be left with the impression that unrest in the financial sector and suffocation of real economy are seen as acceptable sacrifices on the path to reining in inflation.
On the other hand, the Euribor hike takes an identical approach to all 20 Member States, failing to consider economic peculiarities and different levels of development. Figuratively speaking, it is like diagnosing 20 patients and then prescribing all of them aspirin in a situation where one has a cold, while others can have tumors, depression etc.
But social dissatisfaction grows out of a much more tangible aspect. Namely that no fewer than 84 (!) percent of Estonian households had a bank loan in 2018 and we have no reason to believe the situation has changed much since then. Therefore, it is little wonder Euribor comes off as a private sector tax with which the consumer has been saddled at the end of the day.
This raises the question of what in this context justifies banks' 14-percent income tax rate compared to the ordinary citizen's standard 20-percent rate on (nearly nonexistent) deposit returns (not to mention the rest of income), on top of all other taxes, and the tax by banks called "Euribor + margin." The recent decision to abolish the tax exemption on home loan interest comes off especially cynical in this light.
Need for debates and courage
Instead of attempts to place blame, I would expect from the state a debate at minimum and solutions at best as shocks to the system of society and economy of this magnitude cannot be met with just the status quo approach. Unfortunately, two camps seemed to emerge from Riigikogu election debates: one that would retain the current tax policy after minor fine-tuning and one which claims to have ready-made solutions, which often stand for a return to tried and tested things.
No party has had the courage to highlight conscious and purposeful experimentation in their program, testing out new ideas, including potential tax reforms in the fiscal dimension. Instead of hitting everyone with universal measures reminiscent of the 2000 tax reform or rising Euribor rate, the alternative could be to adopt a step-by-step approach to introducing new tax policy. Such an initially limited in terms of time and space reform or application of new ideas would allow policymakers to learn from the results and make adjustments to avoid potentially wider damage to society.
International experience can once again be relied on, for example, by using so-called sunrise and sunset provisions that are applied automatically if certain conditions are met. Everyone likely agrees that experimentation in whichever area of policymaking might also culminate in having to admit that the experiment failed to produce results and failed. However, this is nothing to be ashamed of as the failure constitutes valuable knowledge in itself and helps avoid stepping on the same rake again in the future. At the end of the day, it is a matter of political culture.
And yet, Estonia has managed to come up with the e-residency program experiment and knowingly conducted experiments with self-driving vehicles on public roads in order to get the lessons in early. Why then should tax policy experimentation be ruled out in the banking sector, R&D and national defense? There are enough questions, and I would hope the new coalition can find the courage to address them.
*Average sector ROA in Estonia 1.88 percent, Latvia 0.9 percent, Lithuania 0.86 percent, Finland 0.68 percent and Germany 0.07 percent.
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Editor: Marcus Turovski