The newly appointed coalition government, consisting of the Reform Party, the Social Democrats and Eesti 200, has declared it plans to keep the state budget deficit below 3 percent of GDP. Without intervention, the deficit was projected to reach 5.4 percent of GDP next year.

To achieve the 3 percent target, the coalition has proposed a plan that includes a 10 percent cut in government spending, which is still largely undefined, and tax increases. These include a general income tax hike of 2 percent, applied from the first euro earned, an increase in value-added tax to 24 percent and a 2 percent corporate income tax.

Peeter Koppel, chief investment officer at Redgate Wealth, described Estonia's public finances as exceptionally poor. He emphasized that the real world usually works based on the rule of, "There are no solutions, only trade-offs." Koppel noted that while this might not fully convey the intensity of the situation, it accurately describes the state of the budget and the unavoidable reality that "there is no money," which does not make anyone happier. The focus now, he added, should be on deciding whose misery would have the least negative effect on the system as a whole.

LHV macroanalyst Triinu Tapver expressed opposition to raising taxes during an economic downturn, citing its adverse effects on economic growth. She pointed out that raising multiple taxes simultaneously exacerbates this negative impact. "In hindsight, it would have been wiser to implement such tax increases during prosperous times when people have more disposable income," Tapver remarked.

Tapver advocates for more extensive spending cuts. "There are still areas where the state can make savings and cuts. There are various programs directed at businesses where substantial savings could be made," Tapver stated. She emphasized that the current approach disproportionately affects ordinary people with modest incomes, which, she argued, is not economically sound.

Company income tax

According to the coalition's plan, a 2 percent corporate income tax will be reintroduced after several decades, expected to generate €208 million annually starting in 2026. However, the specifics of how this tax will contribute to the budget in its initial year remain unclear. Even the finance minister acknowledged in a Friday interview on Vikerraadio that the details are still being worked out.

Triinu Tapver does not view the corporate income tax as inherently harmful to the business environment. While acknowledging that taxation does not favor entrepreneurship, she expressed doubt that any business would cease operations solely due to this tax.

Peeter Koppel, on the other hand, interprets the move as more symbolic and ideological, suggesting it reflects a "soft-Marxist" attitude towards business. "This step seems to me like a cosmetic and symbolic gesture rooted in ideology. There's a trendy, somewhat soft-Marxist attitude towards business and entrepreneurs, with little recognition that taxable value is actually created by businesses," Koppel commented.

"We are not Norway, where money comes from the sea. Therefore, we objectively need an extremely favorable business environment, where the number of entrepreneurial experiments is as large as possible. The more experiments, the greater the likelihood of success, wealth creation and consequently tax revenue for the state and an improved standard of living for everyone," Koppel added.

He continued, "We have gradually adopted a European mindset where accumulating wealth is somewhat suspicious, and therefore it shouldn't happen too often – so let's regulate and tax! The introduction of a traditional corporate income tax, which will likely gradually increase, is a blow to our business environment at a time when we need to increase the number of experiments."

Bank of Estonia economist Kaspar Oja stated that a low corporate income tax might not be entirely negative for businesses. Oja suggested that a low tax rate could reduce business owners' reluctance to withdraw funds from their companies.

"With only a dividend tax, it is unreasonable to withdraw money from the company. If some part is taxed immediately from the profit, then the disincentive to withdraw money becomes smaller," Oja noted.

Additionally, Oja pointed out that in Estonia, business income is generally taxed much lower than wage income, which encourages schemes to reclassify ordinary work as business activity, thereby avoiding taxes. He suggested that the taxation of labor and capital income could be harmonized to address this issue.

VAT and income tax hikes

Starting this year, the value-added tax (VAT) increased by 2 percentage points to 22 percent. According to the new coalition's plan, it could rise again by 2 points to 24 percent in July next year. Additionally, the income tax rate will increase to 22 percent next year, and in 2026, an additional 2 percent income tax will be introduced, applying from the first euro earned, which will affect all income levels, including low-income earners.

Tapver from LHV noted that further increases in VAT could lead to a decline in consumption. While essential expenses will still be covered, luxury spending is likely to decrease. "Overall, consumption might be lower than, for example, what the Bank of Estonia has forecasted," Tapver remarked.

She also suggested that increases in VAT and income tax rates might prompt people to ask for higher wages, which could, in turn, contribute to further price increases. "However, we know that many companies are already struggling, and some are just beginning to feel the impact of rapid wage growth and rising input costs," Tapver noted.

The analyst assessed that the government's tax increases, combined with reduced consumption and the postponement of the abolition of the so-called tax hump, could negatively impact Estonia's economic growth. "For example, the Bank of Estonia has forecasted economic growth to return next year. Basically, you can disregard that economic forecast, because all the assumptions it was based on no longer hold," she stated.

Koppel noted that both income and consumption tax increases are regressive, meaning they disproportionately affect poorer people more than wealthier ones. "This is bad and unpleasant. However, the negative impact of increasing consumption taxes on the economic environment tends to be generally smaller than other measures," Koppel said.

Kaspar Oja also suggested looking at VAT from a broader perspective, beyond just its short-term effects. "Much has been said about the short-term effect of VAT, that it is regressive, which is true, but there has been little discussion about its long-term effects," Oja commented.

He explained that VAT is essentially the only value-added tax that uniformly taxes imports, labor income and capital income. "There are very few taxes that tax capital income in the same way as wage income. Additionally, VAT does not tax exports, which makes it quite beneficial from a competitiveness standpoint," Oja remarked.

Reducing the deficit

Estonia has committed to keeping its budget deficit within a maximum of 3 percent of GDP. Recent years have seen significant increases in spending on healthcare, education and national defense, and the Reform Party's plan to eliminate the tax hump, or Estonia's gradual basic exemption reduction scheme, requires additional funds.

Experts agree that efforts to reduce the deficit are prudent. Triinu Tapver noted that while Estonia's public debt level is low, the rapid growth of this debt is concerning, and reducing the deficit is a wise move. "It's right to move towards not letting this gap grow too large," Tapver said.

Peeter Koppel also supports reducing the deficit, acknowledging that while one could philosophize about how the developed world's debt burden might gradually "dissolve" in an inflationary environment, making a more liberal approach to deficits possible, he doubts that the state would want or be able to rely on such a scenario. "Personally, I believe that this 'dissolution' is a very likely scenario, but I don't think the state would want or could count on it," Koppel said.

However, Koppel noted that he sees some positive signs for Estonia's economy overall. "I see that in Sweden, they have started borrowing significantly again. This indicates an improvement in our external environment, which is clearly more important than our local maneuvering. We are still an export-based economy, and the likelihood that we will become something else is very small," Koppel remarked.

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