On Monday, the coalition agreement signed by the Reform Party, the Social Democrats and Eesti 200 outlined the implementation of a defense or security tax consisting of three parts. This includes a 2 percent tax on turnover starting in July 2025, a 2 percent tax on individual incomes beginning in 2026 and a 2 percent tax on corporate profits also starting in 2026.

Initially, the public perceived these changes as standard tax increases. However, while the increase in value-added tax (VAT) and the introduction of corporate income tax are conventional, the individual income tax is not. Äripäev was the first to report on this.

Currently, Estonia has a progressive income tax exemption system, which is expected to remain in effect until the end of next year according to the coalition. For working individuals, incomes up to €1,200 per month are partially exempt from tax, with €654 being tax-free. This exemption decreases as income increases, until it is fully phased out for individuals earning €2,100 per month.

Pensioners receive an additional benefit, with a tax-free minimum of €776 per month. According to the Ministry of Social Affairs' spring estimate, the average pension in Estonia this year is €774 per month, meaning the average pensioner remains within the tax-free threshold.

If only the income tax rate were increased, the tax burden on lower-income individuals would not significantly rise. For instance, a pensioner receiving €774 per month would be fully exempt from the tax increase.

Currently, an individual earning the minimum wage of €820 per month takes home €763, paying €27.3 in income tax. Next year, due to a previously decided increase, the income tax rate will rise by two percentage points to 22 percent, resulting in a monthly tax of €30 for someone earning €820.

Implementing a new 2 percent income tax exempt from the tax-free minimum would further increase the tax burden. For a person earning minimum wage, this would mean an additional €15.8 per month in taxes, or €190 annually.

A pensioner with an average pension would pay €15.5 per month in income tax, or €186 annually.

This is in addition to the planned VAT increase, which the coalition intends to raise from the current 22 percent to 24 percent in 2025. However, reduced VAT rates for items like medicines are expected to remain unchanged, with only the top VAT rate affected.

The Ministry of Finance has not disclosed detailed calculations on these tax changes, citing that the data is still preliminary. However, they provided an image projecting the impact of the VAT increase and the new income tax on Estonian household incomes by 2026.

The image applies the 2 percent additional income tax to all individual incomes. Green represents income tax, blue represents VAT and red combines both. Each decile consists of 56,000 households. The first decile includes the poorest households, while the tenth contains the wealthiest.

The monthly net income for the lowest-income households could average around €600, while for the wealthiest, it could be about €3,500. The fifth decile's income might be approximately €1,200. Estimates can be found here (.pdf).

Households in lower deciles tend to be smaller, as there are more pensioners in the second to fourth deciles. The estimate of household members is approximate.

According to the Ministry of Finance's chart, lower-income households will pay a larger portion of their income in taxes due to the new tax increases compared to higher-income households.

However, this chart does not present the complete picture. Starting in 2026, Estonia is set to implement a universal tax-free minimum. For individuals earning up to €1,200, the abolition of the so-called tax hump will have minimal impact, but for higher-income individuals, especially those earning over €2,100 per month, the impact will be significant.

For instance, in 2024, a person earning €2,100 will pay €405 in monthly income tax, which will increase to €445 in 2025. However, in 2026, the tax will decrease by €116, dropping to €329.

The extension of the tax exemption somewhat mitigates the increase in tax burden for higher-income individuals. The breakeven point, where the abolition of the tax hump and the higher income tax do not affect income, is around €4,000 per month. Beyond this point, the tax burden for higher earners will start to rise due to the increased income tax, but it will still be less than it would have been without the elimination of the tax hump.

The exact additional revenue expected from the new taxes is unknown, but Prime Minister Kristen Michal (Reform) shared calculations from the Ministry of Finance, indicating that the new income tax could generate €361 million annually, the VAT increase €244 million annually and the 2 percent corporate income tax €208 million annually.

On Tuesday morning, as the prime minister hurried to the Riigikogu to take his oath of office, he declined to provide detailed comments on the tax plans. He simply stated that they are necessary to cover security expenses.

"The defense tax is broad-based; through VAT, income tax and corporate taxation, the entire society contributes to the growth of defense spending, the purchase of new munitions and the assurance of internal security. The tax is temporary, lasting until 2028, and its goal is to ensure internal security. For other expenses, the government will make a 10 percent cut," Michal explained.

According to slides published last Friday, the coalition forecasts that the new tax increases will generate between €813 million and €884 million annually. This includes the VAT rate increase that took effect this year, with the additional revenue amounting to about €1 billion annually starting in 2026.

Against this, the coalition has set increased and increasing defense expenditures, along with additional national defense investments starting in 2026, which the tax hikes are supposed to cover. These are the same additional investments that former Estonian Defense Forces (EDF) chief Martin Herem advocated for.

However, there are no earmarks in the state budget. It does not matter from which source expenses are covered. When considering the overall change in the tax burden on individuals, the abolition of the tax hump must necessarily be included in the calculation. The previous government estimated the first year's cost at €430 million and subsequently at €300 million annually.

In contrast, a comprehensive analysis commissioned by the Ministry of Finance and conducted by the University of Tartu, published last spring, estimated the cost of implementing a uniform tax-free minimum income at up to €650 million annually.

Former finance minister: Burden almost imperceptible

Annely Akkermann (Reform), chairman of the Riigikogu Finance Committee and former finance minister, said, when commenting on the situation of people in the lowest income decile who stand to lose the most from the tax change, that the increased loan burden should not be difficult to shoulder.

Replying to Vikerraadio "Uudis+" host Arp Müller's suggestion that the defense tax will hit hardest 56,000 households in the first or least fortunate decile of earners whose income after tax will shrink by 3.4 percent, which might amount to more than a few meals, Akkermann said," Well, [2 percent] of €500 comes to €10 per month. I believe it is manageable quite imperceptibly."

Akkermann also suggested that the defense or security tax is broad-based. "No matter how rich or poor you are, security is a shared benefit, which no one can finance by themselves. Everyone needs it, which is also why the tax hits everyone. And 2 percent on income should not be felt in everyday consumption," she found.

The article was updated to add comments by Annely Akkermann.

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