Sikk, I. 2012. Fiscal consolidation in Estonia. GREAT Insights, Volume 1, Issue 3. May 2012. Maastricht: ECDPM
This article provides an overview of the Estonian approach to fiscal responsibility, including societal and political consensus on deficit spending and examples of lessons learned from consolidation process. Estonia has a well-rooted culture of fiscal responsibility and extensive experience with consolidation during the 2008-2010 period, amounting to 17% of GDP.
There were numerous factors supporting the success of the consolidation. The relatively small size of the country and buffers of 11% of GDP collected during the previous years provided a favourable precondition for quick reactions to the changing economic environment. Estonia has followed sound fiscal management since the transition in the early 90s and has a natural preference for conservative fiscal policy. The fact that Estonia had currency board-backed fixed exchange rate from 1992 until 2011 and accessed the Eurozone in 2011 also played an important role.
Being an open economy, Estonia is very much dependent on the conditions of the European economy and the world at large and thus the fiscal stance has to be highly adaptive. When world trade collapsed in late 2008, Estonia’s exports plunged by nearly 50% during the first half of 2009, and financial flows in the banking sector almost stopped.
Facing a simultaneous domestic shock the Government took a rather consistent line at the very outset of the crisis. Immediate measures were taken to maintain the credibility of state finances and to keep fiscal position within the Maastricht limits. Very strong political commitment can be considered as the main success factor of consolidation: the balanced budget rule has been in the coalition agreement for a decade.
Another supporting factor was lack of public objection. The consolidation need was well taken on board by the society – there were no protests on the streets, although most segments and sectors were affected by the consolidation.
The scope and measures of consolidating
No budget lines were saved from consolidation – the logic that almost each and every budget item can be cut was employed. Another realization was that laws could be amended to enable consolidating: 29 laws were modified with the negative supplementary budget of 2009.
Some examples of consolidation measures, on the expenses side, include a 20 % cut of operational expenditures of the public sector, lower increase of pensions from 2009, suspending government co-payments to the II pillar pension funds for 2009 and 2010 and gradual resumption of payments thereafter, reduction of health insurance costs by 8%, major cuts of road maintenance, local government funding, and defence budget.
On the revenues side, actions were taken to raise the unemployment insurance tax, the alcohol, fuel and tobacco excise, and the VAT, lowering of the income tax was temporarily stopped and additional dividends from state owned enterprises were paid. In short, the expenditure and revenue side measures were balanced, and EU funds were effectively used to save the pace of economic growth.
The fine-tuning of the budgeting process entailed useful legal discussions for the Ministry of Finance, and was a trigger in starting serious discussions on structural reforms, such as for example social security and education reform.
Effects of the consolidation
The Estonian economy emerged from the crisis with a substantially stronger fiscal position. From the point of view of the Ministry of Finance the consolidation had positive side effects, as it was used to improve public financial management. It resulted in increased control over other general government areas of expenditure, and increased capability to assess general government budget position, as more advanced tools and techniques for planning and monitoring were introduced. The consolidation also shifted the mindset of Estonian politicians, public administrators and the general public with regards to budgetary issues.
In order to be able to withstand economic downturns, one needs to be prepared. In practice this translates into budget surpluses resulting in fiscal reserves in good times to introduce countercyclical budget policy during the times of crisis. This ensures that there will be no need to borrow in turbulent times, when interest rates are high, to stimulate economic activity.
Budget surplus can be achieved through a balancing of the budget at times when GDP levels are above their potential – revenue windfalls during the boom years must not be spent. Keeping the structural budget position in balance and letting automatic stabilisers work helps to create confidence in public finances.
It is advisable to have fiscal rules in place. The rules are especially important in almost every country in times of change of the government. Legal framework of fiscal rules backs the sustainability of the fiscal system and curbs governments in pushing though irresponsible policies.
The balanced budget rule is the best known rule. However, it is usually not enough due to the tendency to underestimate cycles. Therefore it is useful to balance the impact of this rule with the expenditure limit rule. Another option is to set expenditure ceilings, which can become expenditure floors in boom periods.
Another key aspect is transparency and political independence of fiscal institutions that enables objective forecast. Keeping the political and public discussions active is essential for successful implementation as it builds ownership. Last but not least, creating buffers is essential for long-term fiscal sustainability.
Ivar Sikk is Deputy Secretary-General of Fiscal Policy, Ministry of Finance of the Republic of Estonia
This article was published in GREAT Insights Volume 1, Issue 3 (May 2012)