Within the countries that make up the heterogeneous mosaic of the eurozone, there is one that stands out for being the epitome of liberalism and frugality. Its economy has been characterized in recent decades by the order of its public finances, the ease of doing business (it ranks high among European countries in the ‘doing business’ ranking), and by having a somewhat peculiar tax system within Europe, as its tax emblem is a flat-tax on income (flat rate in the personal income tax -IRPF-) of 20%.
This country also has the lowest debt in all of Europe. Its indebtedness has historically been so low that the European Central Bank (ECB) admitted to having trouble finding its debt in the market during its large stimulus programs. But this model economy faces an emerging fiscal problem: its public deficit is at record highs (the government estimates it at 3.5% of GDP for this year and 5.3% for 2025) and its public debt has doubled in four years. Tallinn is facing an economic crisis and a dilemma about its economic paradigm.
Estonia is an example for much of Europe in many segments of its economy. This small country has become a digital hub for financial and other companies. Some media outlets have even dubbed this Baltic country as the ‘European Silicon Valley’. Its low taxes and business-friendly regulations have attracted foreign investment, allowing the country to develop rapidly and almost seamlessly. The per capita GDP of this economy has multiplied by nine since 1995, making it the most developed Baltic economy according to this indicator.
But if anything has stood out so far, it has been the obsession of its governments with fiscal stability. For years, Estonia’s public debt has remained at levels close to 10% of GDP (Spain, for example, multiplies that percentage by more than 10). However, the COVID-19 pandemic and Russia’s invasion of Ukraine have been two very harsh blows to this economy. The debt is now around 20% of GDP.
The country is facing an endless recession and, in a few years, the public deficit has set two historical records, and now the government must decide whether to raise taxes or cut public spending to return the country to the desired fiscal balance. The storm is hitting the government of Prime Minister Kaja Kallas hard, as they continue to face a budget deficit while facing pressures to increase defense spending to 3% of GDP.
Estonia has recently been in economic headlines for experiencing the longest recession in Europe, with eight consecutive quarters of GDP contraction from the first quarter of 2022 until the fourth quarter of 2023. The pain for this economy of 1.3 million inhabitants and nearly 38.000 million euros has been aggravated by the echoes of war and a slowdown among its Nordic neighbors. The weak performance of Sweden and Finland has harmed them.
“In the past, when Estonia went through an economic crisis, it emerged from it thanks to the recovery of exports,” said Rasmus Kattai, head of economic policy and forecasting at the Bank of Estonia, in statements late last year. “Now it is exports that are problematic. It will be a long and difficult recovery,” explained the Estonian.
Trade has been disrupted by the developments in the region, where the collapse of the Nordic real estate market, the depreciation of the Swedish and Norwegian currencies, and the increase in electricity costs in Estonia have contributed to the slowdown. “The collapse in demand from the Scandinavian and German markets has caused a decline in goods exports, which in turn has led to a drop in private sector investment,” Erste Group said in a report on the Baltic country’s economy.
The International Monetary Fund (IMF) emphasizes in its latest report on Estonia the difficulties facing an economy trapped in a recession. Contrary to expectations of a recovery in the second half of last year, economic activity contraction continued, along with stagnant productivity and weak external sector performance.
Nothing is currently supporting Estonia’s economy: “Weak demand from key trading partners and a loss of competitiveness have depressed exports, forcing companies to cut their investments. Although the labor market remained strong and companies retained employees until recently, the increasingly complex prospects for an imminent recovery and the rise in real wages have begun to gradually take a toll on employment. Unemployment is increasing, combined with stricter financial conditions, weighing on disposable income and private consumption despite higher real wages,” warns the IMF.
All this is causing precisely this ‘mess’ in public accounts, a ‘mess’ that is a problem for Estonia but would be a blessing for debt-ridden southern European countries that have been suffering from public deficits above 3% for years and a debt-to-GDP ratio exceeding 100%. The IMF highlights that Estonia is a country with little tolerance for debt and needs to balance its accounts to prevent market tension.
Darts from the Central Bank
There is no certainty that just by hoping for an improvement in tax revenues, the State budget situation in Estonia, sinking deeper into a growing deficit, will turn around and improve, declared in early April Madis Müller, Governor of the Bank of Estonia and also a member of the ECB’s Governing Council.
In statements to a national television news program, Müller was clear: “What will reduce the State’s revenues next year are the planned tax changes in income tax legislation: the introduction of a tax-free income for all will lead to a significant drop in State revenues from personal income tax. This is one of the reasons for next year’s higher deficit.” Since January 1, 2024, a uniform basic tax exemption of 8,400 euros has been applied to all individuals, replacing the current tax exemption, which depends on the amount of annual income.
“Furthermore, the improvement in the economic situation will be quite gradual and, hopefully, will stem from stronger exports. However, export growth does not mean much in terms of additional tax revenue. On the contrary, a very strong labor market until now means strong tax revenue, both from income tax and social security contributions,” added the central banker.
Regarding deficit forecasts, Müller admitted they are quite concerning and stated that “in a situation where the economy is still relatively fragile, it is not realistic to balance State spending and revenue this year or next.” “Even more worrying is that the Ministry of Finance’s forecasts up to 2028 show no signs of improvement, unless additional decisions are made to increase taxes or significantly cut spending,” he concluded.
Baltic or Nordic paradigm?
“Estonia is facing difficult decisions on fiscal policy. It is projected that the budget deficit will reach 3.5% of GDP this year, with risks biased upwards due to potential revenue deficits. It is expected that the public debt/GDP ratio, although low, will increase during the forecast horizon, and interest payments are taking up an increasingly larger proportion of expenditure,” the IMF elaborates in its report.
But the problems do not end there. The relatively low tax pressure is a blessing for its citizens, who have more disposable income in their pockets, but it is also a problem for a Government grappling with a recession: “At the same time, spending pressures are accumulating. The emerging needs to strengthen national security and accelerate the energy transition add to spending pressures related to aging… Overall, there is a broader question emerging about whether to maintain the country’s competitive fiscal environment or move towards a social welfare model with a broader provision of public services and a more robust social safety net,” the IMF points out.
No beating around the bush: Estonia is facing a major dilemma. On the one hand, it can choose to reshape its tax and fiscal system to align with the rest of Europe: higher taxes and more public spending in exchange for more generous social benefits and a more protective State (Nordic paradigm). On the other hand, it can opt for spending cuts to bring finances into balance and maintain the prevailing narrative: a highly competitive tax pressure and a dynamic economy. The solution is neither simple nor magical.
