Since 2020, Estonia has implemented a fiscal policy with an unusually deep deficit. This fiscal policy needs to change, but there are a lot of myths in society about why the problems have arisen, what sound public finances mean and how to get there, writes Raoul Lättemäe.
Estonia's historical and post-independence simplified understanding of fiscal policy is quite different from what is considered good public finance elsewhere in the world. Only a couple of decades ago, central government budgets in Estonia were planned in absolute balance, essentially denying the role of fiscal policy in smoothing economic cycles.
Similarly, the proverb about "the debt of a stranger" overlooks that, when it comes to covering costs that provide long-term benefit for society, such as infrastructure investment, it is sometimes desirable to spread such costs between generations through borrowing. That is, purposefully intended public debt is not necessarily bad.
Commonly, economic growth is cited as the solution to the problem of public finances, without calculating the unrealistic expansion of the economy required to flee the current predicament. Similarly erroneous is the myth that the entire deficit can be eliminated through cuts and efficiencies in the public sector, without compromising the quality or quantity of broader public services.
The problem with Estonia's fiscal policy is not that Estonia will turn into Greece overnight, although there is a risk. Our debt burden is, after all, one of the lowest in Europe.
The problem is that the fiscal deficit policy of the last three to four years was not a deliberate policy choice resulting from in-depth strategic discussion that shaped long-term policy, but the result of contradictory decisions taken rather haphazardly, as an afterthought.
As a consequence of this fiscal policy, our debt burden has increased by approximately 10 percentage points of GDP, but it is difficult to see what our society has received in return for this increase in public debt.
Therefore, the concern is not the level of debt, and in the case of conscious borrowing, not even its future growth, but rather the fact that the current debt has not been designed deliberately, and as a result, we have received relatively little long-term value for debt. And the current difficulties are not so much the result of unpopular decisions that were made, but rather of unpopular decisions not made.
It is common to refer to the needs of the crisis years, but direct crisis spending only partially explains the persistent budget deficit that has emerged to date, as the suspension of the implementation of European budget rules permitted not only crisis spending, but also the pursuit of diverse policy ambitions and the planning of new fixed spending without adequate funding sources.
The four-year pause in budgetary demands made it possible to delay controversial decisions for a very long time. Under the guise of years of crisis and budgetary pauses, there has been an ambition to establish a state with both generous public services and subsidies and a low tax burden.
Four years is also a sufficient amount of time for society to anticipate that this will persist. Tax increases are unpopular, but there is still a wish to make adjustments in order to preserve the public services we use. Such a two-pronged strategy cannot be maintained over the long term, and a fundamental choice must be made between increasing the tax burden to maintain or enhance the quality of public services or decreasing the quantity of public services to maintain the current tax burden.
This does not imply we have to go back to the historically simplistic understanding of fiscal policy. Mathematically, it is not necessary to have a surplus in order to accumulate reserves, as the general government debt-to-GDP ratio is calculated to stabilize at a deficit of -1.0...-0.75 percent of GDP, and with a better-than-budgetary position, the debt ratio will start to gradually improve even with a deficit ratio. In the case of a pan-European policy, it is prudent for a Member State to employ fiscal policy to ease the economic cycle.
It is important to note that Estonia's historically very conservative fiscal policy has its origins in the post-independence period and in the reform package developed by international organizations in the late 1980s. However, international organizations' perspective on economic policy has changed significantly over the past three decades. There has been a substantial increase in integration and interdependence between countries, and the international financial safety net has undergone a major overhaul to prevent countries from being left alone during severe crises.
This is because, in general, countries are unable to implement what was articulated at the end of the 1980s in this form, or the necessary reforms are exceedingly painful from a social standpoint. A situation where all countries in the world would build up large individual national reserve buffers is not really healthy for the global economy either, for various reasons.
Estonia and a few other countries in Eastern Europe have been the only exceptions where the former reform package succeeded, but probably only because there was a very strong consensus in society on the need for reforms to move from a planned to a market economy. The rapid economic convergence also mitigated the social cost.
Now that we are one of the world's 40 wealthiest nations, there appears to be less consensus in society regarding the size of the state apparatus, its purpose, fiscal policy, and tough measures. The internal political consensus on conservative fiscal policy started to crumble already a decade ago, around the mid-2010s.
This likely contributed to the fact that, under the guise of years of crisis and a pause in budgetary rules, many contradictory actions were taken: fixed costs were planned without an increase in tax revenue, and tax cuts were proposed without a reduction in the quality of public services.
The current precarious condition of the public finances cannot be blamed solely on the years of crisis, but also on the delaying of difficult decisions. It is true that the political risk of stopping socially popular but economically unfeasible measures is usually high, and postponing such a decision appears safe. However, it is also true that the cost of delayed decisions can be hefty.
It is also popular to talk about kick-starting the economy as a solution. In reality, hoping for economic growth will not save us from this situation. The required jump in GDP is simply too big.
Bringing public finances into compliance with the current (but in the process of being amended) state budget law would require a four-year "leap" from the current level of approximately 80 percent of the EU average to 107 percent of the EU average or the U.K. average.
The previous rise in living standards took us 20 years of effort and was much easier because of the lower starting point. Of course, rapid economic growth, and hence tax revenue growth, would be helpful, but it is not realistic to expect such a rapid jump in living standards through economic growth alone. There are also no economic policy steps that can achieve such a miraculous leap in living standards through public investment or incentives.
We must also recognize that some of the factors that have allowed us to have a low tax burden have been temporary. When compared to other European countries at comparable levels of wealth, Estonia has had the luxury of maintaining the national tax burden approximately 4 percent lower of GDP, thanks to non-existent interest costs and continuous higher EU subsidies.
Both of these sources are on the verge of depletion, and this, coupled with the persistent deficit problem of the past few years, will have a negative impact on public finances. In other countries with a comparable standard of living, the expenditure on the state apparatus has been about 5 percent of GDP, while in ours it is about 3.5 percent. If you rely solely on cuts to the state apparatus, then, from a merely mathematical perspective, the solution will not work even if the entire apparatus is eliminated. If we want to maintain a low tax burden, we will have to forego some public services.
Greece's kind of collapse is a risk, but it is avoidable. Excluding interest costs, our public sector is comparable in size to that of the Netherlands in 1999 or Italy in 2005, assuming a level of prosperity equivalent to Estonia's current standard of living. But in the Netherlands, the same thin public sector was compensated by a much higher contribution from the private sector, which we do not seem to want, and in the case of Spain and Italy, interest costs were covered by deficits, which fueled further increases in debt and interest costs, which we also do not seem to want.
In-depth analysis of these numbers reveals that our priorities differ significantly from those of old European nations with comparable levels of prosperity. We spend significantly more on defense, leisure, culture and religion, education and homeland security and significantly less on social protection, the maintenance of the state apparatus and the economy. This distribution and future path that Estonia wants is a matter of political choice.
The key to solving Estonia's long-term fiscal policy challenges can only stem from the fact that in a democratic society the word "politics" means the art of compromise. However, with these political choices, we seem to have reached a situation some time ago where no party has a sufficient mandate in society to impose its views unilaterally, but each party has sufficient power or resources to exclude, or at least restrain, solutions that do not suit it. This confrontation, rather than seeking compromises, increases the risk of public finances becoming unsustainable.
Thus, the only solution to the long-term challenges lies in the art of finding the necessary compromises between politicians on the long-term role and size of the state apparatus to move Estonian society forward. This presupposes a substantive socio-economic debate in which the question of where, how and in what way we want to develop as a country takes center stage.
Only after reaching a suitable consensus on this problem will we be able to create a consistent and sustainable economic policy, as well as a position on the ideal amount of debt and the necessary fiscal policy flexibility and limits. In creating long-term sustainable fiscal policy, calculating the quantitative impact of particular initiatives in millions of euros is the last, not the first, question.
The Ministry of Finance's website has an overview of the current position, history, and long-term issues of fiscal policy in Estonia, on which this article is based. This work summarizes the various analytical inputs made between the spring parliamentary election campaign and the preparation of the fiscal strategy for 2024-2027, and thus does not reflect the RES' proposed balancing measures: the broad-based national defense tax, zero-based budget cuts, or other steps still under development on the basis of the RES.
Editor: Kaupo Meiel, Kristina Kersa