Analyst warns Estonia’s budget deficit may become permanent

Estonia’s state budget deficit appears likely to persist, bringing higher debt and interest costs, LHV analyst Triinu Tapver told ERR while commenting on the Finance Ministry’s summer economic forecast.

Tapver said the main figures in the ministry’s latest macroeconomic forecast were broadly similar to LHV’s forecast updated in mid-summer. LHV expects economic growth of 2.2 percent and inflation of 3.3 percent this year, followed by growth of 2.6 percent and inflation of 2.5 percent next year, assuming the external environment stabilises.

She said consumption and investment growth were expected to accelerate. Investment would initially be driven mainly by the state’s defence and infrastructure spending, although much of the defence equipment would be bought abroad, meaning a relatively small share of that money would enter Estonia’s economy.

Tapver said defence spending was primarily an investment in security rather than an economic stimulus comparable to ordinary investment. Private-sector investment has not yet gained clear momentum, but gradual growth could emerge next year.

Improving consumption should increase state revenues through value-added tax and excise duties. However, Tapver said it was difficult to assess the size of the effect because about 85,000 people had not yet begun using their tax-free allowance on a monthly basis. Their future behaviour will determine how much of the additional income reaches consumption and, in turn, tax revenues.

The Finance Ministry forecasts that consumption expenditure will grow more slowly than incomes in 2026. Since higher-paid people benefited more in euro terms from the income tax changes, some of the additional income could go into savings or the repayment of existing obligations rather than consumption, Tapver said.

“It cannot therefore be assumed that higher net income will immediately translate into an equivalent increase in consumption and tax revenues,” she said.

At the same time, defence spending and other more permanent expenditures are increasing, while income tax changes and declining revenue from the sale of carbon dioxide emission allowances are limiting the growth of budget revenues. Although stronger consumption will support receipts from consumption taxes, it may not be enough to offset rising expenditure, Tapver said.

“At present, it appears that the budget deficit will remain permanent, meaning that both the debt burden and interest costs will continue to grow,” she said. If interest rates remain high, servicing new debt will also become more expensive.

Tapver said the economy could continue to improve while the state budget faced structural pressure. If expenditure and debt grow faster than revenues, the government will eventually have to intervene by raising revenue through new or higher taxes, reducing expenditure, or both.

Several important spending decisions for the coming years have yet to be made, meaning the budget’s actual path could differ significantly from current forecasts, she said. Economic recovery, improving consumption and expected growth in private investment would create a more favourable environment for the budget. If growth becomes broader-based, the tax base will also improve, but stronger years should be used to rebuild a sufficient budget buffer before the next economic downturn, Tapver said.