IMF says Estonia should take decisive steps to restore its competitiveness

IMF says Estonia should take decisive steps to restore its competitiveness
The Estonian economy has been shrinking for the past two years. / bne IntelliNews
By Linas Jegelevicius in Vilnius April 17, 2024

The Estonian economy, which has been shrinking for the past two years, will start growing again gradually from 2025 but this needs to be helped along by decisive government action, according to the International Monetary Fund (IMF), BNS, a Baltic newswire, and, the website of national Estonian broadcaster ERR, reported on April 16. 

The IMF issued its report at the end of an official visit by a delegation, which lasted nearly two weeks.

The Estonian economy has been in a prolonged recession, the IMF noted, and despite expectations of recovery in the second half of last year, there has been an extended contraction, along with stalling productivity and weak external performance.

The slow start in the year is set to hold back average 2024 growth to a slight contraction of  -0.5%, but the recovery should gain further momentum in 2025, the IMF reported.

Measures to boost competitiveness and counter structural headwinds are a priority, the IMF said.

While unemployment is rising in manufacturing and construction, skill shortages have constrained growth in information and communication technology and vacancies are reported in defence, healthcare, and education, the IMF added.

The IMF noted that recent shocks have triggered supply-side disruptions and a large rise in inflation. Inflation has now eased, but price and cost levels have shifted up compared to the euro area average, hurting competitiveness, while low and falling productivity growth could take a further toll on external performance and weigh adversely on Estonia's longer-term growth prospects, the IMF noted.

The IMF also finds that the scope for lifting immigration quotas should be assessed, while ensuring that minimum sectoral salaries properly reflect skills and qualifications.

Following this year's neutral fiscal stance, the IMF argues for a return to fiscal consolidation, which would rebuild policy space as the economy exits recession, alongside decisive structural measures to lift productivity and financial policies to preserve bank capital buffers.

Ultimately, Estonia is facing difficult fiscal policy decisions. The budget deficit is projected to reach 3.5% of GDP this year, with risks of a greater potential revenue shortfall.

The government is debating how to lower the deficit and appears to be focussing on spending cuts, while economists have called for tax changes and measures to boost growth.

Minister of Finance Mart Vorklaev told AK cuts would be: "Simply put, 1% of GDP on health care, 1% on social support, and then 1% on defence; in addition, we have interest expenses of 1% of GDP."

Talking to the ETV news show Aktuaalne kaamera (AK), Vincenzo Guzzo, who headed up the IMF delegation, said: "As the economy regains ground, we are back to economic expansion this year, then I think it will be important to build fiscal consolidation."

Guzzo said that fiscal expansion would not help to gain external competitiveness, and the country needs buffers that are important when dealing with expanding needs in the future. 

"So for all these reasons I think it is very important that there is I guess collectively a sense of responsibility about the importance of tackling both spending and the revenue side," he added.

The IMF recommended in its report that the Estonian government identify revenue measures worth 1% of GDP already planned in the budget strategy, that it accelerate the implementation of updated land taxable values and lift the exemption on primary residence plot  and consider introducing a property tax. 

The IMF was also in favour of the much-debated car tax as a means of raising revenue. The organisation recommends the Estonia authorities "promptly adopt" the planned car tax, which it notes is both a registration and road tax, with the dual objective of raising tax revenue and supporting a more ambitious green transition.

The IMF said the combined effect of a higher personal income tax rate and a basic allowance for all taxpayers is set to lower revenue and reduce the overall progress of the tax system from 2025. Estonia should assess whether the structure of the tax system meets the intended degree of progressiveness, as a result, the IMF added.

The IMF pointed to the domestic debate on the tax environment and whether a move towards a social welfare model with a broader provision of public services and a stronger social safety net will take place.

Commenting on the IMF report, Bank of Estonia (Eesti Pank) Governor Madis Muller said it had "rightly drawn attention to the issues with the Estonian economy which need to be addressed".

Muller also agreed with the IMF's call for decisiveness from the Estonian government.

"For example, when introducing the car tax, which the IMF also says is something that should definitely be taken forward, the budgetary situation remains complicated enough," he said.

"For instance, these hitherto unspecified, so-called defence-related tax increases, which are discussed in the state budget strategy, but which have not actually been elaborated on should still be moved forward, and some kind of decisions should be made on this," the central bank's governor went on.