The new look of Estonian fiscal policy June 08, 2017

Urmas Varblane
Member of the Fiscal Council

The European Union's experience of the most recent economic crisis highlighted the need for coordination of economic policy, and especially fiscal policy. To this end, all the member states were obliged to introduce national fiscal rules and to set up an institution to analyse fiscal policy and assess how well the rules are adhered to.

Estonian fiscal policy had earlier already been run for a long time on the principle of a balanced budget, and in 2014 this was written into the State Budget Act. To take better account of the economic cycle and its impact on tax revenues, the requirement for the annual budget balance was set in structural terms. Now, after only three budgets have been passed following this requirement, successfully it would appear, the new government coalition is changing the fiscal rules. The new rules will permit the general government a structural deficit if structural surpluses have previously been built up.

The need for strategic investment is given as the justification for permitting a structural deficit. Carefully thought through investments by the state are of course beneficial, but the worry here is that we are trying to make investments by using a deficit while making only very passive use of the Structural Funds available from the European Union. Last year only 70% of the money available from Structural Funds was used, meaning 245 million euros was left unspent. Government investment fell by around one tenth over the year. Why can’t we manage to make investments at the appropriate time? Is the organisation of our public procurements behind the times, or is there some other bottleneck in the regulations? Before extra money is put into circulation, the bottlenecks restraining investment should be removed.

There is no need for stimulation

The Fiscal Council is also worried about the timing of the change to the fiscal rules, as we see a danger of additional measures to stimulate the economy being passed at a time when there is no real need for them. The Fiscal Council recently assessed the spring forecast of the Ministry of Finance, which serves as the basis for the spring budget documents of the government, which comprise the state budget strategy for the next four years, the stability programme, and this time also the state budget for the next year.

Though the Council approved the outlook for growth in the economy and inflation contained in the spring forecast, the estimate of the cyclical position of the economy was again a cause for concern. This is because the government is planning its activity starting from the important assumption that the position of the Estonian economy in the years ahead will be worse than usual, meaning the output gap will be negative. The Fiscal Council does not accept this estimate at all, as employment in Estonia is above its average, unemployment is below its average, and productivity is growing more slowly than wages. Further evidence of the good shape of the economy is the recent news that the Estonian economy grew by 4.4% over the year in the first quarter of 2017.

Contradictory times

The indicators that are used for estimating the cyclical position of the economy have been in contradiction to one another since the Fiscal Council first started work. GDP growth has been low, while conditions in the labour market have been really good. Our opinion is that this contradiction arises primarily because GDP growth in recent years has been held back by various one-off factors like problems in the transit industry or the problems caused more widely in the energy sector by the fall in the oil price. Attention should also be paid to tax receipts, which also describe the cyclical position of the economy. Despite the disappointing GDP growth, revenues from taxes increased by an average of 7% a year in 2014–2016. Such a rate of growth is hard to maintain for a long time.

It is worth noting here that such a contradiction is not unique to Estonia as other countries in Central and Eastern Europe also saw only modest GDP growth in 2015–2016 though their employment rates were higher than their average of the past ten years and unemployment was likewise below the average. This could be a sign that the long-term economic growth in all those countries has slowed and so methods for estimating the cyclical position of the economy that do not focus sufficiently on labour market indicators may give inaccurate signals for planning fiscal policy. In consequence, the government and the private sector should always consider the wider picture in their planning, and not focus only on a single estimated indicator of the cyclical position of the economy.

The deficit may be wider than expected

The fiscal forecast is less certain than usual this year because the details of several of the planned tax changes are not yet sufficiently clear. From observing the current discussion in the government coalition about the tax changes, it is not certain whether all the drafts proposed will come into force at the intended time and in the form proposed. In sum, the Fiscal Council considers that the structural deficit of the general government could be larger in 2018 than the government is planning for.

The planned changes to the fiscal rules have also been prepared in a very short time. The reputational risk caused by the volatility and unpredictability of the procedures for setting the fiscal rules and tax policy is a serious problem. If the government decides to loosen the fiscal rules but is at real risk of not meeting them in their very first year, it will understandably not have a positive impact on the credibility of those rules or of the whole of fiscal policy.

Published: 01.06.2017
Published in: Äripäev