Republic of Estonia. Action Plan for Growth and Jobs for the implementation of the Lisbon Strategy

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1 Republic of Estonia Action Plan for Growth and Jobs for the implementation of the Lisbon Strategy Tallinn October 2008

2 CONTENTS CONTENTS...2 INTRODUCTION BRIEF ANALYSIS OF THE COMPONENTS OF ECONOMIC GROWTH MACROECONOMIC ENVIRONMENT...10 OBJECTIVE 1: ENSURE A STABLE MACROECONOMIC ENVIRONMENT...14 OBJECTIVE 2: DEVELOP A TAX SYSTEM THAT STRONGLY PROMOTES ECONOMIC GROWTH...17 OBJECTIVE 3: ENSURING THE LONG-TERM SUSTAINABILITY OF FISCAL POLICIES COMPETITIVE BUSINESS ENVIRONMENT...26 OBJECTIVE 4: INCREASE THE INTERNATIONAL COMPETITIVENESS OF RESEARCH AND DEVELOPMENT ACTIVITIES...26 OBJECTIVE 5: INCREASE THE PRODUCTIVITY AND INTERNATIONAL COMPETITIVENESS OF ENTERPRISES...37 OBJECTIVE 6: DEVELOP A BUSINESS ENVIRONMENT FAVOURABLE TO ENTERPRISE AND ENTREPRENEURSHIP 47 OBJECTIVE 7: ENSURE THE SECURITY OF ENERGY SUPPLY AND DEVELOP A COMPETITIVE AND ENVIRONMENTALLY-FRIENDLY ENERGY SECTOR EDUCATION AND LABOUR MARKET...67 OBJECTIVE 8: IMPROVE THE SKILLS OF THE LABOUR FORCE...69 OBJECTIVE 9: INCREASE THE FLEXIBILITY OF THE LABOUR MARKET AND IMPROVE THE QUALITY OF WORKING LIFE...87 APPENDICES...95 APPENDIX 1: THE COMPOSITION OF THE WORKING GROUP CO-ORDINATING THE ESTONIAN ACTION PLAN FOR GROWTH AND JOBS APPENDIX 2: FINANCIAL PLAN BY MEASURES FOR THE ESTONIAN ACTION PLAN FOR GROWTH AND JOBS

3 INTRODUCTION The Action Plan for Growth and Jobs is the Government strategy for increasing the competitiveness of the economy. The plan sets goals to increase the Estonian work force to 80% of the European Union average, to increase scientific and development activities up to 2% of GDP and the growth of overall employment to 70.5%. The Action Plan for Growth and Jobs helps implement the European Union s growth and jobs strategy. In 2005, the Government approved the Action Plan for Growth and Jobs When compiling the new plan, the effectiveness of the measures applied during the last period and the current status of the main areas influencing Estonian competitiveness were thoroughly analysed. The Estonian Government together with European Commission has analysed the components supporting Estonian economic growth compared to other European Union Member States. The results of the analyses are the basis for setting the main goals and emphasises of the measures in the plan. In addition, the recommendations by the European Commission 1 regarding Government policy for economic competitiveness and the conclusions of the European Council competitiveness summit 2 that took place in the spring of 2008 were taken into account when compiling the plan. In general, both the analysis of the components of economic growth and the conclusions of the commission show that Estonia has developed rapidly in recent years and the overall level of competitiveness is good. At the same time, both external and internal risks have increased significantly. In order to maintain and increase the competitiveness of the Estonian economy it is necessary to take several new steps (incl. first of all to increase export capacity and develop the skills of workers) and adopt sound policy to develop the economy. The Government sets 9 central objectives and 29 sub-objectives in the plan for the year 2011, and plans the measures, a timeline of activities and the funds necessary to achieve them. European Council conclusions from spring 2008 and points-to-watch streamlined in the Commission s 2007 Annual Progress Report form the basis of the NRP. Main objectives set and measures undertaken are directly responding to the Commission assessment. As all the objectives are measurable and measures are listed with concrete timetable and financial allocation, there was no need to compile separate action plan for points-to-watch implementation. In line with the new three years cycle, brand new NRP is developed. Therefore, separate reporting of old measures is not enclosed. Relevant information on main concrete actions in 2007 and 2008 as well as status of implementation of main measures is broadly covered in situation analysis subchapters of the NRP and more concretely under each sub-objective. The financial plan of the Action Plan for Growth and Jobs is in compliance with the State Budget strategy for , the 2008 State Budget Act and the draft 2009 State Budget Act presented to the Parliament by the Government. Implementation of some measures enclosed to the reform plan does not have direct budgetary implications (for example development and enforcement of legislation), in those cases finances are not foreseen in the financial plan. There 1 The European Commission brought up 6 points that the Estonian Government should pay more attention to when developing a competitiveness policy. The suggestions and recommendations were made to all the states in the report issued in December 2007 by the Commission of European Communities ( annual-progress-report/ countries-specific-recommendations_et.pdf). Estonia was one of six Member States that the European Commission did not offer official recommendations, only drew attention to certain issues. 2 The conclusions of the European Council are available at the following website: 3

4 are cases where final financing decisions are not yet made by the government (impact assessment is on-going), in those cases relevant columns in the financial plan are left empty and will be complemented after decisions are made. Financial costs of the measures include EU funds and are cash-based. Therefore, yearly costs are indicative and can undergo minor annual adjustments based on implementation results. Costs for the years 2010 and 2011 could be revised during annual budgetary processes. Financial plan of the NRP covers finances need for the implementation of measures in years , even when the implementation period of measure is longer. Preparing the plan has involved close cooperation between Ministries and the active involvement of Government partners and experts. The completion of the Action Plan for Growth and Jobs was coordinated by the competitiveness working group 3 in several Ministries put together by the Secretary of State. The State Chancellery started coordinating the compiling the new Action Plan for Growth and Jobs in January of In the first phase, there were discussions with partners in order to map out key issues and possible solutions in the areas of macro-economics, the competitive business environment as well as education and the labour market. The timeline for the plan, initial priorities and main emphasis were introduced to the Economic Affairs Committee, Cultural Affairs Committee and Social Affairs Committee during the discussions of the opinions of the European Council in spring. After meeting with partners, the descriptions of problem areas were prepared for each goal of the Action Plan for Growth and Jobs based on the current status of the area and the issues brought up by the partners, and measures were defined in order to find solutions. After thorough discussions and agreeing upon the key activities necessary for achieving the goals, the Action Plan for Growth and Jobs was discussed at the Government meeting on May 22, In June, the discussion of the action plan took place at the European Union Affairs, Social Affairs, Financial Affairs and Cultural Affairs Committee and in September at the Economic Affairs Committee. The plan, followed up by the suggestions of Parliamentary committees, was sent to the ministries and partners for a final revision. From July 1 to August 17, the Action Plan for Growth and Jobs was opened for public discussion at the participation portal 4. During the completion of the action plan several new ideas were raised for increasing Estonian competitiveness implementing those ideas would not be rational without a thorough analysis of the effects and discussions of the details of implementation. The discussion and analysis of those ideas continues. New steps will be added to the plan next year if possible. In addition to implementing internal measures, the Estonian Government has given more attention to developing strategic cooperation with neighbouring states. Coordinated decisions with neighbouring states in key areas help to increase the competitiveness of the entire region. In April of 2008, a joint meeting of the Estonian Research and Development Council and the Science and Technology Policy Council of Finland took place. Cooperation between Estonia and Finland in the area of research and development was discussed at the joint meeting, and several suggestions for more active cooperation were made to the Government. The Prime Minister of Estonia has commenced the development of strategic cooperation reports with Finland and Latvia. 3 Composition of the working group is available in Appendix 1 4 A more detailed activity scheme of the process of completing the Action Plan for Growth and Jobs is available at the following website 4

5 In June of 2008, the authors of the strategic cooperation report in Estonia and Finland (Finnish diplomat, former ambassador in Estonia, Jaakko Blomberg, and the vice president of Nordic Investment Bank, Gunnar Okk) presented the prime ministers with suggestions for developing cooperation. The main purpose of the report was to offer ideas for how cooperation between Estonia and Finland could help them manage better with challenges arising from globalisation and help each other increase their competitiveness. Public discussion of these suggestions is ongoing. At the same time, an analysis of the possibilities of implementing these suggestions is also under way. In the autumn, the Estonian Government will discuss the priorities of Estonian- Finnish cooperation and the principles of implementing the suggestions. Based on those discussions, the measures for regional cooperation will be added to the Estonian Action Plan for Growth and Jobs next year. The objectives of the Growth and Jobs strategy are also supported by the European territorial and cross-border cooperation programmes that are financed from the European Regional Development Fund. With the help of these programmes cooperation between Estonian and neighbouring countries is enhanced in many priority areas of the Estonian Action Plan for Growth and Jobs. The Strategy Director at the State Chancellery, who is also the coordinator of the European Union strategy for growth and jobs in Estonia, coordinates the implementation of the action plan. An overview of the implementation of the plan is presented to the Government every year before October 15. Every year, if necessary, the plan is amended based on the analyses of the effectiveness of the implementation of the plan. The effectiveness of the implementation is also assessed by the European Commission each year who presents a report to the leaders of the Member States in December. 5

6 1. BRIEF ANALYSIS OF THE COMPONENTS OF ECONOMIC GROWTH The economy of Estonia has grown rapidly in recent years. We have come significantly closer to the EU average level of GDP. At the end of 2007, Eurostat assessed the level of Estonian GDP as already over 70% of the EU average. Table 1: Estonian gross domestic product (accounting for purchasing power) for GDP annual growth 9,6% ,7% ,8% ,1% ,5% ,2% ,4% ,3% GDP per person EU27 average 44,7% 46,2% 50% 54,5% 57,4% 62,2% 67,6% 70,8% Source: Eurostat Since the middle of 2007, economic growth has slowed significantly. Real growth of GDP in 2007 dropped to its lowest level in 7 years. In 2008, the economic slow-down has further accelerated. According to the 2008 summer prognosis from the Ministry of Finance, real growth of Estonian GDP in 2008 is expected to be negative ( 1.0%). The primary danger in the next few years is the possibility that the economic standstill in Estonia will last several years. At the same time, the basic economic situation has not significantly changed other than the increase in labour costs and the cost of capital, and broader challenges are not dependant on GDP growth in a single specific year. Up until 2007, GDP growth in Estonia was influenced first of all by changes in employment figures and the productivity of the workforce. The growth of Estonian GDP in the last 8 years has mostly been influenced by a continual growth in productivity. During the last two years (especially 2006), GDP growth was also influenced remarkably by the sudden increase in the number of employees. As a positive sign, the productivity of the workforce also continued to grow at a greater rate compared to other EU Member States during the period of rapid increases in employment (2006 and 2007). When analysing the strengths and weaknesses of Estonia, it is important to compare the main components that influence GDP growth with similar data on other countries (see Figures 1 and 2). The basis of the action plan is the comparison of Estonia with average EU15 indicators 5. GDP growth is influenced by three main groups of factors: 1) demographic factors, 2) the level of labour utilisation (which is largely employment figures and the number of working hours) and 3) productivity. In order to provide a more precise assessment, the analysis of these factors concentrates on the following components (see Figures 1 and 2). Regarding demographic factors, the primary sub-components include the number of permanent residents, the birth rate and the size of the working age population. The main components influencing the level labour utilisation include the number of work hours per worker, unemployment and employment rates among women, men, youth and seniors. Productivity growth is mostly influenced by capital intensity, total-factor productivity (TFP) and the education of workers. Analysis of the demographic and the workforce application sub-components provide us a good overview of the Estonian situation compared to the average in EU15 countries, and in terms of changes in recent years. The productivity sub-components are less transparent because one of the 5 The EU15 average level is taken as a basis for the comparison, because the European Commission also compares the progress of the Member States with the EU15 average when analysing its Lisbon process. 6

7 important sub-components, total factor productivity (TFP) 6, is basically not analysed using a comparative methodology across the EU member states 7. The following figures show the components influencing Estonian GDP growth in comparison with other EU Member States and the change trends in these components in recent years 8. Figure 1: Comparison of the levels of components of average GDP in Estonia and EU15 according to 2006 data Gap with EU15 in level in 2006 GDP per capita Demographic components Labour market components Labour Productivity Figure 2: Comparison of the growth rates of the GDP components in Estonia and EU15 for Growth differences vis-à-vis the EU GDP Demographic components Labour market components Labour Productivity Fertility Share of foreign population Share of Working age Population Native Population Net Migration Share of Working age Population Youth Participation Male Participation Female Participation Participation Unemployment Rate Average Hours Worked Youth Participation Male Participation Female Participation Participation Unemployment Rate Average Hours Worked Capital Deepening Total Factor Productivity Initial education (Labour quality) Capital Deepening Total Factor Productivity Initial education (Labour quality) Source: The Commission of European Communities Average real economic growth in the last 10 years has been approximately 7% per year. During the period , Estonian economic growth was the fastest among European Union countries averaging around 8% per year. As a result, convergence with the average level of EU economic prosperity has also been significantly faster than expected (see Figure 2). At the same time, GDP per person compared to EU15 is still low, the main reason for 6 Factor productivity includes everything that takes place in the internal processes of economic entities (mainly enterprises). It is greatly influenced by the level of implementing technology, the economic aspects of the processes within the enterprises, the effectiveness of everyday leadership etc. 7 The analysis of economic growth is based on the analysis called Lisbon Assessment Framework completed by the European Commission, which aims to assess the factors influencing the economic growth of all Member States. 8 The horizontal line on the graph shows the difference between the Estonian and EU15 levels as a percentage. Data from 2006 is used because more recent comparative data for EU Member States is not yet available. Demography is the aggregate indicator of the three sub-components and demonstrates how much population processes have influenced working population figures compared to the EU15 average. Labour utilisation shows how much Estonian people work. Among other things it views how many work hours there are per worker. Total factor productivity is explained above. 7

8 that has been the relatively low productivity (approximately half of the EU15 average). This low productivity level is related to both low TFP as well as capital intensity, which has grown quickly compared to other EU countries, but continues to be one of the most modest in the European Union. Basically, this means that companies have invested little, considerable human resources are being consumed, relatively inexpensive products are being produced and services with low added value are being offered. During the period , most of the components influencing Estonian economic growth have grown faster compared to average growth in EU15. Growth has been fastest for productivity components (capital intensity and TFP). Unemployment indicators have also improved rapidly. Due to the high birth rate in the 1980s, the weight of the working population has increased. During the period , the Estonian situation worsened compared to the EU15 average only in regard to the birth rate and migration. Those components also grew, but growth was faster in other EU countries compared to Estonia. Estonia's greatest strength is labour utilisation. This is supported by both the high percentage of the working age population (which will start to decrease significantly in the coming years) as well as employment, which is higher than the European average. The high employment rate among women and seniors (aged 55 64) is especially positive, where Estonia has already achieved the ambitious goals of the Lisbon strategy. Compared to the average of EU15, there are relatively less men employed in Estonia and the rate of youth employment is also lower than the average in the EU. The latter is largely related to the high percentage of young people obtaining higher education. The decrease in the birth rate in the 1990s has not yet influenced the working age population, but its significant influence will appear in the coming years. At the same time, the proportion of non-citizens in Estonia, which is higher than the EU15 average, sets clear limits on the potential for bringing in foreign workforce, which several EU Member States have used to increase workforce capacity. The main goal is to increase the productivity of the workers, which means first of all to make better use of the current workforce. So far the growth of the Estonian working age population has been hindered by greater emigration compared to the EU15 average. In all, there are still more workers in Estonia than the EU15 average. In addition to employment indicators, the greater number of hours worked in Estonia compared to the EU average also helps to keep the level of labour utilisation high (i.e. people work less in Western European countries). In all, this means that people in Estonia work (workers and the number of hours worked combined) around 30% more per person than is done in Western European countries on average (see Figure 1). Considering the fact that Estonians already work more every week now than the EU average, that the level of employment has increased rapidly in recent years and that the number of youth reaching working age will decrease in the next few years, it will be hard for Estonia to make any considerable increase in the level of labour utilisation in the coming years. In order to increase prosperity in the future, first of all the productivity of Estonian enterprises must grow. It is possible to increase productivity by further developing products and services, and by offering more complex and expensive products and services in the same field (e.g. by moving up in the production value chain). In order to support this kind of development it is important to improve the investment environment in Estonia and to develop well targeted and if necessary also more specific national measures, which is one of the goals in the Action Plan for Growth and Jobs. An important component that supports productivity growth is the level of education among workers and the development of their skills. Even though the education component in Estonia is 8

9 a little stronger than in EU15 countries, it is possible to improve the development of employee skills significantly. In order to do that we must make the different educational levels more compatible with the needs of the labour market and to contribute to in-service training and active labour market measures. In developing employee skills, changes in the structure of the economy must be considered, which will take place in the processing industry in the near future, and also in the construction sector, which has grown rapidly in recent years, but will now begin to decrease. The growth of real salaries as a percentage has reached two-digit figures, and the price of other production inputs has also grown. It is likely that the economy will be restructured in favour of those economic sectors and enterprises that are capable of successfully exporting their products in spite of rising expenses. Increasing export capacity is also important in ensuring high economic growth because economic growth in recent years has been faster than expected and relied heavily on loans; in other words, foreign savings and the capacity for loans to support growth in domestic consumption has for a large part been exhausted in Estonian society. Therefore, it is important to develop employee skills, promote the establishment of companies that create higher added value and promote the reorganisation of the work of existing companies. On the basis of this analysis of components influencing GDP growth and other important international developments, the key challenges facing the Estonian Government in ensuring continual economic development are as follows: 1) to develop education based on the needs of companies, and modernise work relations in order to increase safe flexibility of the labour market; 2) to increase the ability of research and development activities, and direct these to be more commercial; 3) to develop an economic and investment environment that supports innovation and international competitiveness of enterprises operating in Estonia; 4) to increase the use of environmentally friendly energy, and at the same time ensure the security of energy supply and the competitiveness of the energy sector. A prerequisite for economic growth and competitiveness is a stable macro-economic environment, conservative fiscal policy and the adoption of the euro in a mid-term perspective. 9

10 2. MACROECONOMIC ENVIRONMENT Economic growth in Estonia for 2005 and 2006 was around 10% the highest figures in the last decade. In 2007, economic growth slowed to 6.3%, and according to forecasts by the Ministry of Finance, it will drop to 1.0% in The Estonian economy is rapidly adjusting from a situation of economic growth that surpassed expectations to a more sustainable level. This development is necessary and expected in order to improve macroeconomic balance; however, the correction has been faster than expected. Various institutions that provide economic forecasts have estimated the length of the adjustment period differently some (including the Ministry of Finance) expect the adjustment to end in 2009, others believe that it will take longer. Figure 3: Real convergence with the EU (percentage compared to the EU27 average) ,9 42,4 42,4 44,7 46, ,5 57,4 62,2 67,6 70,8 70, * GDP per capita (PPS) Labour productivity per person employed Price level PPS - purchasing power standard Sources: Ministry of Finance, Eurostat The exceptional economic growth of recent years was primarily supported by increases in domestic demand, the annual growth of which slowed to 7.5% in 2007, but remained higher than GDP growth. According to the 2008 summer forecast by the Ministry of Finance, domestic demand in Estonia will fall in 2008 due to decrease in both private consumption and investments. In 2009, economic growth shall increase again reaching 2.6% due to renewed growth in domestic demand and increased exports. The growth of domestic demand is supported by increased private consumption as well as by growing investments (Ministry of Finance). According to Statistics Estonia, growth in exports was modest in 2007, and this contributed to economic growth falling to 0%. The fall in export growth was primarily caused by reduced export capacity in two categories of goods (fuel imported for processing and electrical devices). The turnover of both categories of goods has fluctuated, but has had a small impact on added value. Growth in exports of other categories continued to increase in Problems with export competitiveness have broadened in In addition to processed motor fuels, vehicles and devices, problems also appeared in several other categories, such as wood, paper and food products, which are important for Estonia. The export of services is mostly hindered by the decline in the transit industry and the supporting areas. 10

11 Figure 4: Real growth of domestic demand and export * Source: Ministry of Finance Export Domestic demand The Ministry of Finance is expecting a slight increase in Estonian export growth figures in In the medium term, the growth of exports appears to remain lower than the average from the last five years evidently because of problems in economic correction. In addition, the growth of foreign demand has slowed in recent years, which again has had an impact on exports. In 2007, the current account deficit reached nearly 18% of the GDP, which is the highest in the last decade. According to forecasts, the current account deficit will decrease significantly in 2008 due to the modest increase in domestic demand and consequently imports. According to the 2008 summer forecast by the Ministry of Finance, the current account deficit will be 11.4% of GDP in Similarly, the gradual fall in the current account deficit will continue over , mostly due to the decrease in the deficit in the balance for goods and profits. Since 2006, inflation has significantly increased in Estonia. In 2006, inflation reached 4.4% and accelerated to 6.7% in An increase in consumer prices in the first half of 2007 was caused by domestic factors; however, in the second half, external factors emerged as food and oil prices rose suddenly in the world market. The consumer price index increased considerably last autumn due to external factors and an increase in excise rates at the beginning of 2008 resulted in inflation of more than 11% in the first and second quarter. According to the 2008 summer forecast by the Ministry of Finance, average inflation in 2008 will be 10.7% and price increases will slow to 6.3% in Developments in the labour market have again been faster than expected in the last two years. In 2006, demand for labour increased dramatically, which in turn decreased the number of unemployed by one fifth and many non-active people returned to the labour market. In 2006, the number of employed increased by approximately 40,000 people (6.4%). A similar trend continued in 2007, when an additional 9,000 people (1.4%) entered the labour market. As a result, opportunities for employers to find additional labour have reduced, putting more upward pressure on salaries. In the first half of 2008, the number of employed has remained stable. By 2009, a slight decrease in the employment rate is expected and a 6.3% increase in unemployment accordingly (the 2008 summer Ministry of Finance forecast). In 2006, nominal growth in wages was 15.8%. Real growth in wages reached 10.9%. In 2007, gross wages went up by 20.4% and real wages by 13%. Given the slowdown in economic growth, the growth in productivity only reached 5.6%, meaning that wages increased about twice as fast as labour productivity, which has been the case for the last two years. 11

12 Figure 5: Real growth in productivity and wages * Labour productivity Source: Ministry of Finance, Statistics Estonia Gross monthly wages Real wage growth exceeding productivity growth has a negative impact on the international competitiveness of companies, and is not sustainable in the longer term. According to forecasts by the Ministry of Finance, average real wage growth is expected to slow to 4.2% in 2008, and in the following years, we will see the conformity of wage and labour productivity growth. In the world economy, we are facing a period of slow economic growth and rapid price growth. Economic growth will slow in 2008 due to downscaling in the US, EU, Asian and Latin- American economies. According to forecasts, economic growth for Estonian trade partners is continues to be strong; however, risks have also increased on those markets. The largest contributions to export demand in Estonia come from the Baltic states, Russia, Finland and Sweden where economic growth has still been faster compared to the European average. Medium term expectations for the Estonian economy are optimistic, although the risk of a long-term slowdown has increased. The precondition for continued long-term growth involves maintaining productivity growth. The majority of economic forecasters find Estonian companies highly capable of adapting to the economic situation and they estimate the period of economic standstill to last for one to three years. It is difficult to give exact forecasts for the near future, as the influence of the slowdown in the world economy has not affected Estonia's neighbouring markets or Estonia yet. The accuracy of forecasts depends on developments in neighbouring countries. The inflow of foreign investments may depend on the course of the Latvian economy, as Latvia is the third largest export market for Estonia. In addition, the availability of loans might decrease considerably in Estonia (as this has already happened to a certain extent) should the financial situation of the Swedish banks worsen significantly. However, the financing ability of Swedish banks has remained the same compared to banks in other countries. The long-term aim of Estonian economic policy is to increase income level close to the level of the old EU member states. Favourable investment conditions for the private sector are necessary in order to achieve the sought after rapid growth. A moderate tax burden is one of the components of the business environment that stimulates growth while leaving sufficient funds for private investors. Such a moderate tax burden requires the general balance of Government revenue and expenditure in the medium as well as the longer term. A budget deficit policy would lead to an increase in the tax burden in the near future, or result in passing the debt burden to future and therefore smaller generations of tax payers. The greatest challenges involved in improving Estonia's macroeconomic environment concern, first of all, enhancing balanced economic growth, including balancing labour 12

13 productivity and wage increases, and meeting the Maastricht criteria on price stability as a requirement for adopting the euro. 13

14 OBJECTIVE 1: Ensure a stable macroeconomic environment Indicator Public balance Consumer price index Explanation of the indicator, including the source The government budgetary position as a percentage of GDP. Source: Eurostat Change in prices compared to the last 12 months. Source: Statistics Estonia Current level Projected level % (2007) 0% 6.7% (2007) 3.5% The main goal of the Government s macroeconomic policy is to ensure macroeconomic stability as well as internal and external balance. Given Estonia's specific situation under a currency board arrangement, fiscal policy proves to be the main instrument for influencing the course of the economy and handling risks that endanger balanced economic growth. Estonia has been proceeding in this manner domestic demand having been limited by a government surplus, which, as recommended, has been considerably larger than planned. Figure 6: Developments of public balance (% of GDP) * Sources: Statistics Estonia, Ministry of Finance The Estonian Government sector has had a fiscal surplus since The Government s 2006 budget surplus reached 6 billion Estonian kroons, which is 2.9% of GDP. That was the first time that all levels of the government sector had a surplus. About 80% of the budgetary surplus was from the central Government, which despite a deficit in the pension insurance fund (302.4 million Estonian kroons), reached 4.6 billion Estonian kroons. The Government s 2007 budgetary surplus reached 6.5 billion Estonian kroons, which is 2.7% of GDP. The central Government and social insurance funds both had a surplus, but there was a budget deficit for local governments of 0.5% of GDP. The Government established a budget for 2008 with a surplus of 1.3% of GDP. Mainly due to decrease in real estate operations, which was larger than expected, and a decrease in consumption tax collected decreased at the beginning of 2008 remarkably. Thus, without cutting government 14

15 expenditures, the budget would not have remained balanced. Estonian Parliament passed a supplementary budget for 2008, which decreases expenditure in the state budget in order to ensure a balanced budget for the Government. A flexible re-evaluation of central Government expenditure in response to the changed economic situation has also taken place when drafting the state budget for 2009, where one of the priorities will be to cut government operational expenditure. A surplus-oriented fiscal policy has enabled the Government to decrease the central Government s debt burden, as a result of which total government sector debt, which had reached 4.3% of GDP at the end of 2006, fell to 3.5% of GDP at the end of Figure 7: Government sector debt burden * 2010* 2012* Central government Source: Ministry of Finance Local government Since the second half of 2006, inflation has been accelerating in Estonia. Since joining the EU, the rapid growth of prices is the only Maastricht criteria concerning the introduction of the euro that Estonia has failed to satisfy. Given the Estonian average harmonized index of consumer prices (HICP) over 12 months and the reference value of price stability calculated on the prognosis of the three EU member states with the lowest inflation rate as given in the forecast by the EC, Estonia is still unlikely to satisfy the inflation criteria within the next two years, and adopting the euro within the following years will be complicated. Figure 8: Inflation in Estonia (percentage) , ,2 10,7 8,2 5,8 4,1 4,4 6,6 6,3 3,3 4,0 3,6 3,0 3,6 3,5 3,4 1, *2009*2010*2011*2012* Source: Statistics Estonia, Ministry of Finance 15

16 Despite the fact that opportunities for satisfying the Maastricht convergence criteria are difficult to predict in the long term, adopting the euro is still one of the priorities for the Government. The Government s Programme for sets out that the government budget will be kept in surplus and the development of fiscal policy concerning excises and resources will focus on adopting the euro as soon as possible. Consequently, several important excise rates were increased to the minimum EU level at the beginning of 2008 in order to avoid additional administrative price pressures at the time when Estonia is more likely to satisfy the inflation criteria (See Objective 2). Thus, the Government s decision to increase excise duty more quickly than previously planned will also affect price rises in 2008 and The consumer price index will be influenced by increased excise duties by 1.5% in 2008 and by 0.8% in Measures 1. Prepare the state budget to ensure a balanced budget for the government sector ( ). 2. Prepare a supplementary budget in 2008 to decrease expenditure in the state budget (2008). 3. Reduce the debt burden of the government sector ( ). 4. In order to promote private savings and investments bring taxation conditions for private securities investments in line with those for investments by legal persons ( ). 5. Ensure the legal and technical preconditions for adopting the euro ( ). 16

17 OBJECTIVE 2: Develop a tax system that strongly promotes economic growth Indicator Labour taxes as a percentage of GDP. Consumption taxes as a percentage of GDP. Explanation of the indicator, including the source Collected labour taxes calculated as a percentage of GDP. Source: Ministry of Finance Consumption taxes collected calculated as a percentage of GDP. Source: Ministry of Finance Current level Projected level ,8% (2007) 16,9% 13,3% (2007) 11,9% Since 2000, the tax burden has been relatively stable in Estonia. The tax burden for 2008 is expected to be 32.2% of GDP and will decrease in the coming years. Decreases in the tax burden are mostly caused by changes in tax policy and decreases in the tax base in comparison to nominal GDP. Labour taxes form the largest share of the tax burden, 17.5% of GDP in Consumption taxes constitute 12.3% and capital tax 2.5% of GDP in Figure 9: Tax burden in Estonia (percentage of GDP) *2009*2010*2011*2012* Source: Ministry of Finance Shifting the tax burden from taxing labour to taxing consumption and the exploitation of resources has been the goal of several successive governments. At the same time, the Government is attempting to keep the tax system stable, simple and transparent with as few exceptions as possible. The Government s goal has been to stimulate work and increase resource efficiency. The proportion of utilisation of labour is high in Estonia compared to other European countries and during the last years, it has even improved due to the favourable economic environment. The high level of labour utilisation is supported by high employment indicators and by the large number of working hours per employee. 9 Explanatory note to the expected levels of the indicators: As a proportion of GDP the total amount of labour taxes will increase as according to the forecast of the Ministry of Finance the income of population increases more quickly than does the GDP. The level of consumption taxes decreases from the high levels of 2007 due to the fact that it can be expected that proportion of domestic consumption will not increase to the previous levels. The effective tax rates demonstrate the actual tax burdens more adequately but this data is calculated based on actual statistics and has a long time lag. It can be expected that the effective tax rates will develop in opposite direction from the indicators above (i.e. labour taxes will decrease, consumption taxes increase). 17

18 In the coming years, the share of labour taxes will be influenced by two different factors: the share of personal income tax will decrease and the share of social security contributions will increase. The share of personal income tax will be reduced from 6% of the GDP in 2008 to 5.1% of the GDP by 2011, the primary reasons for which are the decrease in tax burden and increase in basic exemption of the income tax. At the same time, the share of social security contributions will increase from 11.7% to 12%, primarily because of the increase in minimum social tax liabilities. Altogether, the tax burden for labour will increase from the 16.8% in 2007 to 16.9% by In 2007, the share of consumption taxes formed 13.3% of GDP, and according to forecasts in 2008 this will reduce to 12.3% of GDP. The share of consumption taxes is negatively affected by the decrease in consumption caused by the general slowdown in economic growth, which significantly decreases the collection of VAT, as well as decreased consumption of excise goods and the consequent collection of excise duties. Figure 10: The structure of the tax burden in Estonia 100% 80% 60% 40% 20% 0% * 2011* Labour taxes Capital taxes Consumption taxes Source: Ministry of Finance Since tax collection has changed for a number of reasons (rapid wage growth, decrease in consumption in 2008 etc), the comparison of effective tax rates 10 illustrates the changes more adequately. During the period , the effective tax on labour decreased by 5.3 percentage points in Estonia. At the same time, the tax on consumption has grown by 2.8 percentage points 11. Despite considerable changes in reducing labour taxation and increasing the taxation of consumption and resource exploitation, the proportions of the tax burden have not substantially changed. The main reason for this lies in the fact that labour expenses (wages) have risen rapidly during the last three years, which has in turn increased the labour related tax. During the period of the current Government, the following essential changes have been made: o According to the amendment of 2007 in the Income Tax Act, the income tax rate will be reduced to 18% (this applies to both employees and enterprises); the income tax rate will decrease from 22% in 2007 to 21% in 2008, to 20% in 2009, to 19% in 2010, and to 18% in In September 2008, the tax reform was postponed by one year. 10 The effective tax rate is an indicator calculated as the actual income tax paid divided by net taxable income before taxes, and it reflects the net rate a tax payer actually pays (all the benefits and actual consumption structure are taken into account). For example, the actual tax burden of consumption is higher than 18% (VAT) because it includes goods that are taxed using different excise and environmental duties. 11 Source: Taxation trends in the EU, Eurostat 18

19 o The amendment of the Income Tax Act prescribes the increase in basic exemption to Estonian kroons per month (2 250 EEK in 2008; EEK in 2009; EEK in 2010; and EEK in 2011). Due to the postponed tax reform, there will also be a one-year delay in the plan to increase the basic exemption. o In summer 2007, the Alcohol, Tobacco and Fuel Excise Duty Act was amended prescribing the following changes for 2008: - In 2008, the alcohol excise rate will increase by an average of 20% and the tobacco excise will almost double (from the current 11 EEK to 20 EEK per a pack of cigarettes, which complies with the minimum liability of the EU). - The gasoline and diesel fuel excise rates will start increasing in 2008 in order to reach the minimum level of the EU (according to the energy taxation directive, this level will have to be reached not later than by 2010); the gasoline excise rate will increase by approximately 25% and the diesel fuel excise rate by approximately 34.5%. - The liquid gas excise rate will be increased from EEK per kg to EEK per kg in The petrol excise rate will increase from EEK per l to EEK per l as of Natural gas used for heat production will be taxed at an excise rate of 157 EEK per m 3 as of Electricity will be taxed at an excise rate of 50 EEK per 1MWh as of The EU minimum excise rate for electricity is EEK/MWh (non-profit purposes) and 7.8 EEK/MWh (business purposes). The government plans to continue the current policy of shifting the tax burden from taxing labour to taxing consumption until For that reason they have decided to decrease VAT specifications and raise state fees. Besides shifting the tax burden from labour taxation to higher consumption taxation, the amendments should have a positive impact on the potential adoption of the euro, and should not have long-term effect on inflation. Later, when Estonia is likely to meet the Maastricht convergence criteria there will be no additional inflation resulting from increased excise rates. Given the large-scale changes in fiscal policy during recent years, the Government is not planning any reforms of a similar scale in the near future. Measures 1. Reduce the income tax rate to 18% and increase basic exemption to EEK per month ( ). 2. Increase the VAT incentive from 5% to 9% and lose the incentives for performances and concerts, waste handling, and funeral goods and services ( ). 19

20 OBJECTIVE 3: Ensuring the long-term sustainability of fiscal policies During the last two years the largest contribution to the long-term sustainability of fiscal policies and managing the effects of the aging population has been an increase in employment rates. In short, during the past two years nearly more taxpayers (approx. 7% of total employment) pay social taxes and so help to improve the state of the State pension insurance and the financial situation of the Estonian Health Insurance Fund. The improvement in employment rates has markedly improved the budgets of local governments and to a lesser extent that of the central government. Last year's positive trend ended in 2008 and a step-by-step decrease in the working age population can be expected in the long term. As of 2008, the long-term sustainably of Estonian fiscal policy compared to other European Union member states is considered good. Government sector debt is the lowest in the European Union and according to short-term plans Government sector debt will remain stable in comparison to GDP. Nearly 70% of the Government sector debt of approximately 8.3 million EEK is owed by local governments. Local government share of debt has risen since Table 2: Government sector debt * 2009* 2010* 2011* 2012* Total debt (% of GNP) 4,3% 3,5% 3,5% 3,3% 3,0% 2,5% 2,3% incl. Central Government 1,7% 1,1% 1,0% 0,9% 0,7% 0,4% 0,3% Local Government 12 2,6% 2,4% 2,5% 2,4% 2,2% 2,1% 2,0% Source: Ministry of Finance The State pension insurance fund, which is under the Central Government, has in previous years (except for 2007) been running at a deficit and will remain so in the years As the pension index calculation policy was changed in 2007, no surplus is expected within the next few years, even with accelerated social tax receipts. As of 2008, the pension fund deficit amounts to 1.2 million EEK and will grow rapidly within the next few years, reaching 3.1 million EEK by It was decided to transfer 1.8 billion kroons from the 2005 surplus and 2.0 billion kroons according to the supplementary 2006 budget to the pension insurance fund reserve (includes previous year s surplus and additional transfers made by law) in order to strengthen the financial position of the pension insurance fund. The pension insurance fund reserve was 6.1 billion kroons as of the end of According to changes to the Accounting Taskforce (RT) policy no 17, which will come into effect on January 1, 2009, local governments must show in their balance sheet liabilities arising form concession contracts, due to which the debt load of local governments will increase and local government balance figures will be retroactively adjusted. The influence of this change will be approximately 2 billion kroons along with the State Realestate Ldt transactions. 20

21 Figure 11: State pension insurance fund financial indicators bil. EEK bil. EEK ,3 0,4-1,2-2,3-3,1-3,1-2, * 2009* 2010* 2011* 2012* pension insurance income I pillar expenses II pillar expenses reserve balance Source: Ministry of Finance -35 Despite relatively large pension insurance fund reserves, the Estonian pension insurance system is in a relatively weak sustainable financial position according to 2008 terms and conditions. According to the Ministry of Finance prognosis, today's reserves will be fully exhausted by 2010, and additional funds from the State budget will need to be utilised in order to make pension payments as planned today. The positive influence of the pension insurance II pillar on the balancing of the pension insurance fund will only be felt decades from now, due to which the pension insurance fund may need additional funding reaching tens of billions of kroons in the meantime. As in most European states, the ratio between pension-aged people in the population (age 65 and over) and the working aged population (15 64 years) will change negatively in the long-term compared to today. Today there are four working age people for every pension-aged person in Estonia; however, according to the Eurostat prognosis; the ratio will be one to three by As in many other countries, many different supplementary pension benefit terms are in general forming a larger burden for the pension insurance fund in Estonia. Nearly 320 million kroons in old-age pension supplementary benefit payments were paid in 2007 to approximately persons of working-age, forming 2.2% of all pension fund expenses. The payment of pensions for persons of full pension age to individuals amounted to 65 million kroons in 2007, forming only 0.5% of total pension fund expenses. Therefore, already today, supplementary pension benefit payments make up 2.7% of pension fund liabilities, forming a direct additional burden on the State budget. Additionally, reduced income for the State budget must be considered, as the payments of supplementary pension benefits reduces people's incentive to work. In general, the financial stimuli offered to workers exceeding the retirement age are good in Estonia, as such workers still receive their pensions in the full amount. As a result, the indicators of employment among older workers are high in comparison with the European Union average. The average exit age from the labour market is also relatively high (even higher than the average retirement age of men and women). 21