The Estonian government sector's budget deficit for last year reached 1.7 percent GDP, according to data published by Statistics Estonia on Tuesday. The state budget, however, had forecast a deficit of 3 percent.

"A 1.7 percent GDP budget deficit last year does indeed seem to be relatively small and good news, considering the context," Müller acknowledged. "It really is, in fact, but as Statistics Estonia also says, updated data will be published in September, and this deficit may currently be underestimated."

According to the governor of the central bank, the discrepancy between forecast and latest published figures might stem from the difficulty of classifying defense sector purchases in accounting. Such was the case last year as well.

"Some expenditures, which we don't yet know whether they should be accounted for in 2024 or 2025, will likely be partially allocated to last year," he noted. "More information about these will come later."

He added that it's also possible that some expenses were pushed to the end of the year in anticipation of tax hikes, which may have contributed to higher tax revenues.

"Overall, from the central bank's perspective, we see that we still have an ongoing problem where state expenditures are consistently exceeding revenues — and this needs to be addressed," Müller emphasized.

Eliminating tax hump adds budgetary pressure

Inflation in Estonia is expected to accelerate this year, once again leading inflation across the EU. The Bank of Estonia is forecasting inflation to rise 6 percent this year.

"Food commodity prices, when looking at the global market in recent months and quarters, have increased on average," Müller noted, adding that they know these increases tend to be passed on to food prices in Estonia relatively quickly.

"Due to the continued relatively fast wage growth, we also expect service prices to keep rising," he continued. "In addition, nearly one-third of next year's price increases will come from various tax hikes, primarily the increases in VAT and the motor vehicle tax. These will all be factored into prices."

Asked about the potential impact on the Estonian economy of eliminating the tax hump, Müller replied that there are two sides to this coin.

"For people, it of course provides relief, and slightly higher after-tax income," he noted. "But from a public finance perspective, it's problematic that we're doing this at a time when the state budget is under pressure, and this will clearly once again increase the projected state budget deficit and create additional pressure."

Increasing debt burden means accounting for growing interest costs

According to Müller, Estonia's debt burden remains among the lowest in Europe overall, but even so, the state budget outlook and the way the country plans to increase its debt burden seem to be on a very forceful trajectory.

Asked if a rapid growth in debt could pose a risk to Estonia's sovereign credit rating, he replied that when taking on additional debt, this growing burden on the state budget and taxpayers must be taken into consideration.

"Just through interest costs alone already," Müller specified. "We're paying hundreds of millions each year in interest payments alone."

The central bank chief said that if its rating does indeed drop and Estonia's government bonds become potentially riskier in the eyes of investors, the latter will typically demand even higher interest rates.

"This means that the interest rate on loans could increase accordingly in the future," he explained. "Not only in Estonia; we've also seen this in the way bond investors have reacted recently, for example, to plans agreed on in Germany to change their fiscal logic and start significantly increasing borrowing. Even in Germany, we saw how what were previously considered Europe's safest bonds quickly depreciated over a short period."

According to Müller, Estonia must be prepared for the possibility that interest rates will rise if the country's finances are not on a sustainable path.

Longer-term perspective key here

Asked if public finances should be managed more flexibly during turbulent periods than with a state budget drawn up once a year, Müller responded that there's room for debate on what the optimal approach would be.

"On the other hand, I feel that the state must also provide stability in its finances to society and the economy," he continued. "Perhaps we should focus on the longer-term perspective of today's decisions, rather than just constantly adjusting short-term."

Müller pointed out that a few years ago, for example, when there seemed to be more flexibility in the state budget, the decision was made to give pensions a one-off boost. What hadn't been taken into consideration, however, was that this larger expenditure would later be indexed, which prompted bigger issues in the following years' budgets.

"A reasonable balance needs to be found there," he noted. "Even the forecasts that the Ministry of Finance and we ourselves draw up for the year ahead — in a changing economic environment, even those can quickly turn out to be inaccurate."

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