Estonia's state budget is deep in deficit. Meanwhile, Russia is waging an aggressive war in the middle of Europe, necessitating a doubling of our current defense spending. In this situation, wise decisions are needed from our politicians. Unfortunately, dogmas and myths about our economic life persist stubbornly.

First myth: There are no wealthy people in Estonia

Recently, I happened to watch a political debate show on television. I saw a former minister comment on the proposal to increase taxes on the wealthy. They said that we don't have rich people here. And that there isn't really anything to take from the few wealthy individuals we do have.

I suspect that many Estonians share this opinion. They are trapped in the mindset that might have been valid in Estonia perhaps a quarter of a century ago.

Let's look at what current data says. Let's compare ourselves with Finland and Sweden (see diagram in Figure 1). It is probably no surprise to anyone that the poorer half of the population in Estonia earns less than the same group in Finland or Sweden. What might be surprising is that the incomes of the wealthy (the top 10 percent) and the ultra-wealthy (the top 1 percent) in Estonia do not lag significantly behind the incomes of the same groups in Finland and Sweden.

We get an even more interesting picture when we compare the assets of the rich and the ultra-wealthy in these three countries (see diagram in Figure 2). Estonia's ultra-wealthy are 1.57 times wealthier in terms of real assets compared to Finland's ultra-wealthy.

Since in Estonia the incomes of the wealthy constitute 38.16 percent, including 14.41 percent from the ultra-wealthy, of the total population's income, higher taxation of these groups could bring hundreds of millions of additional euros to the state treasury each year.

Second myth: The developed West has dropped progressive income tax

In Estonia, the phrase "progressive income tax" has developed a spine-chilling effect. It is believed that rapidly developing Western countries have long discarded such a tool and consider a flat tax rate more modern, fair and effective. After all, Estonia wants to be successful and modern. The campaign against progressive income tax is accompanied by the slogan that "redistributing wealth does not increase wealth."

The fact is, however, that all developed Western countries use a progressive tax system. In Western countries, the top tax rate is typically between 45 and 50 percent, applied to incomes that are four to five times the average income (OECD Tax Database, 2023).

The high taxation of high incomes primarily serves two purposes. First, it prevents the development of excessive inequality. Second – and this is even more important – it is a means of increasing state revenue in the least harmful way. This is exactly what Estonia desperately needs right now.

Third myth: Higher taxation of the wealthy hinders growth

The belief that higher taxation of higher incomes reduces economic growth is widespread not only in Estonia. This claim has been examined in numerous scientific studies, but researchers have not reached a definitive consensus.

The consensus on this issue is that an excessively high top tax rate is not beneficial for the economy, but the debate revolves around whether the optimal top tax rate is 40, 50 or 60 percent. The top tax rate has been adjusted up and down in various countries over time, but no developed democratic country has abandoned the progressive income tax system.

Fourth myth: Higher taxation amounts to punishing the wealthy and successful

One reason that drives Estonian voters to choose parties that favor the wealthy is the argument of fairness. According to this argument, it is unfair to punish people with higher taxes who have earned their wealth and high income through hard work. In the same category is the claim that entrepreneurs should be supported because they create jobs.

Both claims have some truth to them. However, there are also serious counterarguments to both.

Regarding the first claim, researchers differentiate between fair and unfair inequality. In addition to the fact that some inequality tends towards the unfair side, the argument of solidarity counters the fairness argument. According to the solidarity argument, many societal expenses must be collectively covered according to one's abilities. These expenses include healthcare, education and national defense.

It is also in the interest of entrepreneurs that all people, including their employees, receive necessary medical care, do not miss out on education due to a lack of funds, and that the country is protected against aggressors. Especially in a war situation, the question is not whether it is fair or unfair to empty the pockets of the rich. Money is taken from those who have it.

As for the second claim – that entrepreneurs create jobs – there are more than enough counterarguments. The state also creates jobs by investing in the education system to produce skilled people for necessary work. New jobs are also created by those who spend their time and resources on training for jobs that society needs.

Nobel laureate economist Joseph Stiglitz has been very critical of the claim that the wealthy create jobs and therefore should be left with more money to create new jobs. Stiglitz explicitly calls this a false concept. Money is never lacking when there is a good business idea. What creates jobs is demand (Stiglitz, 2016).

Is Estonia's current economic downturn the result of a lack of capital? No, it is not. The real reason is that demand has fallen in the markets where our entrepreneurs sell their products.

Fifth myth: abolishing the 'tax hump' would put pressure on the state budget

A widely circulated claim is that eliminating the tax hump (Estonia's gradual basic exemption reduction scheme – ed.) would cost €550 million, as the state treasury would receive that much less in tax revenue each year.

The current marginal tax rate for personal income tax in Estonia is depicted in Figure 3. The marginal tax rate describes how much tax a person has to pay for each additional euro earned. For example, if a person's gross salary is €1,000 and they receive a raise of €100, they get to keep €80 of that raise. If another person's gross salary is €2,500 euros, they also get €80 from the €100 raise. However, if a third person earns €1,800 per month and gets a raise of €100, they only pocket €65.5 euros from that extra hundred.

A progressive tax system typically features increasing marginal tax rates that form an upward staircase. The problem with Estonia's tax system is not that the tax rate increases with income, but that it later decreases.

There is no justification for a person earning more than €2,100 to receive 80 percent of a salary increase while a lower-income individual gets only 65.5 percent. This tax hump is an unsightly error that needs to be eliminated.

The problem is that the cost of eliminating the tax hump has been set based on the Reform Party's perspective. If the hump is removed by applying a 20 percent tax rate instead of 34.5 percent for incomes between €1,200 and €2,100, it will indeed cost the state treasury hundreds of millions of euros annually. However, the hump can be eliminated differently.

If the middle class has endured a 34.5 percent marginal tax rate for several years, this rate could be extended to higher incomes, meaning those over €2,100 per month. Such a removal of the tax hump would bring hundreds of millions of euros to the state budget. This would mean introducing a normal progressive income tax, which is currently supported by only a minority of parties.

Of course, the tax hump can also be eliminated in a third or fourth way. This includes, for example, a so-called tax-neutral reform, which means the state treasury would receive the same amount of revenue as it does now, but without the hump. The tax brackets can be adjusted up and down just enough to remove the hump while maintaining the same revenue.

In any case, the €550 million price tag for eliminating the tax hump is arbitrary. The high price tag makes removing the tax hump unpopular. Even parties that actually support a normal progressive tax system now wish to postpone it.

Finally

Of course, a progressive personal income tax is not a magic wand that will solve all our problems. Wastefulness in the public sector cannot be tolerated, although it is not easy to identify. It is also challenging to combat the various schemes that entrepreneurs use to evade taxes.

One side effect of Estonia's "business-friendly" approach is that it is becoming increasingly difficult to access healthcare in the public sector. I have experienced this myself, and friends have described situations where patients are told there are no available appointment slots, but they are offered a paid appointment either on the same or the next day. Right-wing thinking has its merits, but overdoing it can eventually have painful consequences.

The belief that Estonia's key to success lies and will continue to lie in the low taxation of the wealthier population is not sustainable. The state budget needs to be balanced, but it is practically impossible to achieve this while maintaining low tax burdens for the wealthy.

Slovenia is the flagship of Eastern Europe's economy, and although it has its own problems, a progressive income tax has not prevented Slovenia from holding the top position in Eastern Europe. In Slovenia, the top tax rate is 50 percent and is applied at a threshold of 4.3 times the average salary (OECD 2023).

Estonia has for some time been the second most economically successful country among Eastern European states, but according to the IMF, Lithuania, the Czech Republic, Poland, Croatia and Hungary have now overtaken Estonia. I am not mocking Andrus Ansip's once-stated goal of reaching the top five wealthiest countries in Europe, because goals should indeed be set high. However, at the moment, we are unfortunately drifting downriver instead.

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