Now is not the time to be putting the state budget in deficit May 10, 2017

Raul Eamets
Chairman of the Fiscal Council

There has been a lot of fuss in the media about the government’s plan to allow the budget to move into deficit and to introduce a range of tax changes. The state budget strategy approved recently by the government for 2018–2021 is based on the spring forecast of the Ministry of Finance, which forecasts the development of the economy out to the year 2021, as its name suggests. The discussion here is intended rather to draw attention to how that forecast is used in setting fiscal policy.

The Fiscal Council considers that the economic forecast describes the expected development of the key economic indicators accurately enough, is cautious enough, and is quite well in line with several other forecasts. The world around us is relatively unstable and it is better to be safe than sorry as they say. Where there is a difference, and what is worth disputing, is the Ministry of Finance’s assessment of the position of the economic cycle.

The assessment of the Ministry of Finance considers that the Estonian economy is currently running at well below its possible long-term trend level, and will reach that level only in 2020. In the jargon of forecasters this is called closing a negative output gap. Received wisdom says that running a budget deficit caused by increased spending may be reasonable in such position of the economic cycle (i.e. with a negative output gap).

The main dispute between the Fiscal Council and the Ministry of Finance is whether we are currently at a position where some resources in society are underutilised. The current labour market indicators show that wage growth is still strong, and the employment rate is at one of its highest levels ever. This does not encourage me to think that there is a great deal of unused available resources in the labour market. Rather it indicates that the economy is in a relatively good state. In the opinion of both the IMF and the Fiscal Council, the negative output gap is much smaller this year and it may pass its long-term trend potential as soon as next year. Of course everything depends on how the calculations are made, but it is always wise to open your eyes and just take a look around the economy. Are there queues of unemployed jobseekers waiting outside every company and factory?

Last summer the experts from the Ministry of Finance also thought that we were doing rather well. Since then the economies of our neighbours have improved and this has indeed improved the outlook for growth in the Estonian economy, at least in the near future. The problem though is that there has been no major increase in investment or in productivity more broadly. In other words there is nothing that would justify assessing Estonia’s potential long-term growth as better than it previously was, meaning the trend has not moved upwards.

Overall this means that the impact of the measures that are intended to revive the economy will not be felt at the most appropriate moment. Of course the Fiscal Council is not opposed to the use of investment to reinvigorate the economy, the debate is about the timing. The fire is burning with quite a strong flame and we are pouring more petrol onto it. Excessive growth in budget spending may make it harder for the private sector to rein in the growth in wages that is already rapid compared to that in productivity, and may make it harder to find the labour resources needed for an expansion of production. It is always good to get a pay rise, but nobody really wants to see companies going bankrupt and jobs being moved to China. If people had to choose between smaller pay rises now and unemployment, most would probably prefer to keep their job.

It is important for the Fiscal Council, and for compliance with the fiscal rules, that the structural deficit of the general government may be larger next year than is planned, and not only because of the estimate of the economic cycle. We are also concerned about the revenue side.

Keeping the general government budget balance at the targeted level depends on a range of tax changes, which in theory should lead to increased tax revenues. The large number of planned tax changes and the complexity of introducing them, which includes disputes in the Supreme Court, may mean that in the worst case several taxes are not implemented. Equally, we are not currently very well able to forecast how consumers, producers and investors will react to the new tax environment. It could just as well lead to a reduction in tax revenues as to an increase.

Estonia has long been an example to other countries in the European Union for how to keep a budget successfully in balance. We now see several possible risks that might dislodge that mentality of being the shining golden child. Is this a good thing or a bad thing... that is a question of political choices.

Published: 28.04.2017
Published in: Postimees