Tallinn, Estonia – May 19, 2025: Estonia is gradually re-emerging from a prolonged downturn but continues to grapple with higher prices and costs, a legacy of previous shocks, while high global policy uncertainty and rising trade barriers hinder a more vigorous recovery. Innovative young firms, a potential growth engine, are constrained by lack of skilled labor and limited access to capital markets. At the same time, fast-rising defense spending needs compound preexisting fiscal imbalances. In this context, the 2025 budget strikes an appropriate balance between sustaining spending efforts and containing the deficit. However, staff recommends implementing a further moderate adjustment starting from 2026 to address growing imbalances, stabilize the debt ratio, and preserve buffers. Carefully calibrated macroprudential policies, decisive domestic structural reforms aimed at easing reallocation of labor and reducing regulatory burden, and a deeper EU single market would be instrumental in building resilience and supporting growth in the medium term.
Outlook and risks.
Estonia is gradually re-emerging from a prolonged downturn. GDP is projected to grow by 1.0 percent in 2025 and accelerate to 1.8 percent in 2026, supported by a looser policy mix. Moderate growth in the euro area and other export markets is seen slowly spilling over to domestic demand, encouraging firms to revisit investment and, to some extent, hiring plans. In turn, better job prospects could support income and consumption. However, the recovery is only gradual with global policy uncertainty and trade barriers preventing a more vigorous rebound. Inflation is set to remain elevated at a 5.3 percent average in 2025, held up by the effects of tax increases and domestic cost pressures.
The economy faces structural challenges. Wages growing faster than productivity and permanent increases in input costs, a legacy of previous shocks, are hindering price-sensitive activities, while production with higher technological content is constrained by lack of skilled labor and limited access to capital markets. Geopolitical developments, rising defense spending needs, and preexisting fiscal imbalances pose significant hurdles.
Risks to growth are skewed to the downside. As a small open economy, Estonia remains vulnerable to higher trade barriers and impaired global value chains, which could derail the nascent recovery. An escalation of Russia’s war in Ukraine or other geopolitical tensions would exacerbate these risks, while increasing commodity price volatility and further raising fiscal pressures. Conversely, a durable reduction of geopolitical tensions, a deepening of the EU single market, and well-targeted domestic structural reforms could sustain medium-term potential growth, which staff currently estimates to be around 1.7 percent.
Fiscal Policy—Sustaining Spending Efforts while Addressing Medium-Term Imbalances
The 2025 budget strikes an appropriate balance between sustaining spending efforts and containing the deficit. In recent years, tensions between retaining a competitive tax environment and moving towards broader provision of public services and a stronger social safety net have resulted in policy uncertainty and a deterioration of Estonia’s fiscal position. Pressures from an aging population, energy security and climate change mitigation, along with interest costs are set to intensify over time, while fast-rising defense spending needs will exacerbate imbalances in the near term. Large revenue flows in anticipation of tax hikes and welcomed consolidation efforts have contributed to a strong fiscal performance in 2024. This year, the deficit is projected to increase to 2.2 percent of GDP under staff’s baseline, as revenue normalizes. However, the negative output gap and the absence of demand-driven inflationary pressures advise against further near-term fiscal consolidation.
But fiscal imbalances are set to grow over time. The authorities have announced a revised defense spending target of at least 5 percent of GDP from 2026. The repurposing of some spare capacity in EU cohesion funds is expected to support some additional spending. While activation of the national escape clause and Estonia’s low debt ratio will allow greater flexibility in the near term, the consequences of increased defense spending on debt sustainability should be carefully assessed.
Further, growth-friendly consolidation is needed starting from 2026. Staff welcomes the authorities’ decision to finance new spending commitments by extending discretionary revenue measures beyond 2028. However, excessive reliance on higher tax rates may ultimately narrow the tax base and undermine the objective of mobilizing higher revenue. Alternative broad-based, growth-friendly options could be considered in the context of a comprehensive review of Estonia’s tax system (more below). Moreover, a further adjustment of 0.5 percentage point of GDP per year relative to baseline will be needed during 2026-30 to stabilize the debt ratio at around 30 percent over the medium term, avoiding abrupt corrections once the country exits from the escape clause and preserving critical fiscal buffers against possible future shocks.
Options to support revenue mobilization should be explored. Estonia’s tax mix has been traditionally reliant on consumption taxes—especially VAT—whereas income taxes are a relatively small share of revenue. Recent and expected changes will further shift the tax burden in this direction. Consumption taxes are easier to collect than income taxes, but higher spending needs may require a broader revenue base, reaching untapped potential. On personal income taxation, the planned introduction of a uniform allowance in 2026 will usefully address the current hump in marginal rates but it may also lower revenue significantly. Staff urges the authorities to consider revenue-neutral alternatives and assess whether any change meets the intended degree of progressivity. On corporate income taxation, the recent decision to backtrack from a levy on profits signals strong preference for Estonia’s distributed profit tax regime, but higher rates on dividends may lead to further earning retention, eroding the revenue base in the coming years. Staff recommends a review of the corporate tax regime, considering alternative options and potential implications for revenue mobilization and long-run investment. As for Estonia’s VAT, the tax is efficient and pressure to introduce reduced rates for certain goods should be resisted. Finally, Estonia collects limited property tax revenue. Staff welcomes the introduction of a motor vehicle tax and the faster implementation of the new land values. However, residential land is still exempt up to a generous threshold. Municipalities should be encouraged to limit the exemption, while tax deferment schemes could mitigate the impact on certain households, especially the elderly. Staff also encourages the authorities to set up a fiscal cadaster in preparation for an immovable property tax in the medium term.
Spending pressures have built up in recent years and need to be addressed. The commitment to contain the growth of the public sector wage bill in the current budget strategy is commendable. To deliver on this objective, it will be critical to limit exceptions granted to line ministries and other agencies in setting up wages. Family and other social benefits have increased significantly in recent years. A household income and asset registry would allow means-testing and better targeting of these benefits in support of low-income families who are really in need, while achieving some cost savings. Pensions are linked to prices and wages through backward-looking indexation. In recent years, adjustments have been applied on top of one-off increases, leading to large government outlays and, potentially, inflation persistence. Staff recommends a review of current indexation mechanisms.
Financial Policies—Carefully Calibrating Frameworks to Evolving Risks
While still contained, financial stability risks have increased. The improved near-term economic outlook and strong passthrough from lower ECB rates to bank lending rates are supporting the repayment capacity of households and firms but are also triggering a revival in credit growth, especially among less significant institutions. Developments in commercial and residential real estate warrant vigilance, given rising vacancy rates and high concentration of real estate loans in banks’ credit portfolios, while supervisory authorities should regularly assess underwriting standards to ensure prudent lending practices. Liquidity is generally ample, but Estonian banks’ growing reliance on foreign funding may also pose risks in case of market dislocations. Cyber risk should be monitored closely and should continue being reflected in supervisory assessments. Capital ratios remain adequate, but new large dividend payouts should be discouraged as they divert potential sources of capital from banks, reducing their ability to build buffers and absorb future shocks.
The current macroprudential stance remains appropriate. Given rapid credit growth and real estate risks, staff supports the decision to maintain the countercyclical buffer at 1.5 percent and asks for caution before returning to the 1 percent positive neutral rate. Staff reiterates the recommendation to continue reviewing bank exposures and ensure that credit risk is properly reflected in risk weights across the banking system, especially for IRB banks.
Estonia has made progress in addressing AML/CFT challenges. Compliance with FATF standards has improved, as reflected in the 2024 MONEYVAL report, which upgraded Estonia's rating on targeted financial sanctions related to terrorism and terrorist financing from "partially compliant" to "largely compliant." However, further efforts are needed to achieve full and effective implementation of the Financial Action Task Force (FATF) standards. Priority should be given to enhancing the money laundering and terrorist financing (ML/TF) risk assessment and strengthening the risk-based supervision of virtual asset service providers.
Structural Reforms—Building Resilience and Fostering Transformation
Decisive action is needed to enhance productivity. Staff’s firm-level data analysis shows that allocative efficiency has declined over time in Estonia, as structural impediments have hindered the flow of labor and capital from less to more productive firms, while declining business dynamism has weighed adversely on productivity. Policies easing reallocation of labor, reducing regulatory burden, and deepening capital markets would therefore be critical in supporting economic transformation and building resilience.
More targeted active labor market policies could address mismatches and skill shortages. Estonia features high skill mismatch rates. Staff welcomes ongoing initiatives aimed at enhancing technical and digital skills, as well as upskilling and reskilling measures. However, collection of granular data on job mismatches could improve the targeting of these schemes. Better aligning education curricula with labor market needs could further address skill shortages. Policies should continue to focus on integrating migrants (especially women) in the most productivity-enhancing way possible. Recently announced plans to ease quotas for immigrants are welcome, while their salaries should properly reflect skills and qualifications across sectors and regions. Progress could also be made in addressing women’s underrepresentation in certain educational fields and occupations, further supporting the recent decline in the gender pay gap.
Efforts to address financial constraints, reduce administrative burden and foster innovation may also support productivity. Deepening the EU single market would let Estonia leverage economies of scale, foster competition, and lower costs, while enabling innovative young firms to access finance more easily and grow. Further developing the Baltic capital market could also help. National structural policies should accompany this progress, supporting business climate and making Estonia a more attractive destination for foreign and domestic capital. Recent efforts to reduce administrative burden and red tape are a welcome initiative. Expediting planning procedures and streamlining reporting requirements would be important steps. Building on recent measures incentivizing R&D spending, innovation could be further supported through collaboration between universities and businesses. Expanding the availability of venture capital and equity financing, including by facilitating investments by second-pillar pension funds, would improve access to finance and promote capital market deepening, while alleviating pressure on public finance.
Ensuring energy security is critical. Reliable connectivity and sufficient domestic production are strategic objectives for achieving stable energy supply. The recent synchronization with the European electricity grid has been a key step. As the country transitions away from fossil fuels, it will need to continue replacing oil shale with alternative energy sources. Staff supports ongoing efforts to facilitate development of renewables and advocates for boosting energy efficiency in the building and road transport sectors.
The mission would like to thank the Estonian authorities for their warm hospitality, close collaboration, and insightful discussions.
