Republic of Estonia: Staff Concluding Statement of the 2025 Article IV Mission
IMF News, May 19, 2025
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- Published: May 19, 2025
Outlook and risks
- GDP projected to grow by 1.0 percent in 2025 and accelerate to 1.8 percent in 2026, supported by a looser policy mix.
- Staff currently estimates medium-term potential growth to be around 1.7 percent.
- Inflation set to remain elevated at a 5.3 percent average in 2025, held up by the effects of tax increases and domestic cost pressures.
- Recovery is gradual; risks to growth are skewed to the downside:
- Vulnerabilities from higher trade barriers and impaired global value chains.
- Escalation of Russia’s war in Ukraine or other geopolitical tensions would exacerbate risks, increase commodity price volatility, and raise fiscal pressures.
- Upside scenarios include a durable reduction of geopolitical tensions, a deepening of the EU single market, and well-targeted domestic structural reforms.
Fiscal policy: sustaining spending while addressing medium-term imbalances
- 2025 budget assessment:
- Strikes an appropriate balance between sustaining spending efforts and containing the deficit.
- Large revenue flows in anticipation of tax hikes and consolidation contributed to a strong fiscal performance in 2024.
- Under staff’s baseline, the deficit is projected to increase to 2.2 percent of GDP in 2025 as revenue normalizes.
- Negative output gap and absence of demand-driven inflationary pressures advise against further near-term fiscal consolidation.
- Growing fiscal pressures and defense spending:
- Authorities announced a revised defense spending target of at least 5 percent of GDP from 2026.
- Repurposing of some spare capacity in EU cohesion funds expected to support additional spending.
- Activation of the national escape clause and Estonia’s low debt ratio provide near-term flexibility.
- Required consolidation:
- 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.
- Revenue mobilization options and tax policy notes:
- Estonia’s tax mix is traditionally reliant on consumption taxes—especially VAT—while income taxes are a relatively small share of revenue.
- Planned introduction of a uniform allowance in 2026 will address the current hump in marginal rates but may lower revenue significantly; staff urges consideration of revenue-neutral alternatives and assessment of intended progressivity.
- Recent decision to backtrack from a levy on profits signals preference for Estonia’s distributed profit tax regime; higher rates on dividends may lead to further earning retention, eroding the revenue base.
- Staff recommends a review of the corporate tax regime and consideration of alternative options for revenue mobilization and long-run investment.
- Estonia’s VAT is efficient; pressure to introduce reduced rates for certain goods should be resisted.
- Estonia collects limited property tax revenue; staff welcomes the introduction of a motor vehicle tax and faster implementation of the new land values, but notes residential land is still exempt up to a generous threshold.
- Recommendations: encourage municipalities to limit the exemption, consider tax deferment schemes to mitigate impacts on certain households (especially the elderly), and set up a fiscal cadaster in preparation for an immovable property tax in the medium term.
- Spending-side recommendations:
- Commitment to contain growth of the public sector wage bill in the current budget strategy is commendable; critical to limit exceptions granted to line ministries and other agencies.
- Family and other social benefits have increased significantly; a household income and asset registry would allow means-testing and better targeting, supporting low-income families while achieving cost savings.
- Pensions currently linked to prices and wages through backward-looking indexation; recent adjustments and one-off increases have led to large outlays and potential inflation persistence. Staff recommends a review of current indexation mechanisms.
Financial policies and stability
- Financial stability risks have increased but remain contained:
- Improved near-term outlook and passthrough from lower ECB rates support repayment capacity and are 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.
- Supervisory authorities should regularly assess underwriting standards to ensure prudent lending practices.
- Liquidity is generally ample, but growing reliance on foreign funding may pose risks in case of market dislocations.
- Cyber risk should be monitored closely and reflected in supervisory assessments.
- Capital ratios remain adequate; new large dividend payouts should be discouraged as they divert potential sources of capital from banks and reduce their ability to build buffers.
- Macroprudential stance:
- Current stance remains appropriate.
- 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 recommendation to continue reviewing bank exposures and ensure credit risk is properly reflected in risk weights across the banking system, especially for IRB banks.
- AML/CFT progress and priorities:
- Compliance with FATF standards has improved; 2024 MONEYVAL report upgraded Estonia's rating on targeted financial sanctions related to terrorism and terrorist financing from "partially compliant" to "largely compliant."
- Further efforts needed for full and effective FATF implementation.
- Priorities: enhance the ML/TF risk assessment and strengthen risk-based supervision of virtual asset service providers.
Structural reforms: building resilience and fostering transformation
- Productivity and allocative efficiency:
- Firm-level data analysis shows allocative efficiency has declined over time as structural impediments hinder the flow of labor and capital from less to more productive firms; declining business dynamism has weighed adversely on productivity.
- Policies easing reallocation of labor, reducing regulatory burden, and deepening capital markets are critical to support transformation and resilience.
- Labor market and skills:
- Estonia features high skill mismatch rates.
- Staff welcomes initiatives to enhance technical and digital skills, and upskilling and reskilling measures, but recommends collecting granular data on job mismatches to improve targeting.
- Better alignment of education curricula with labor market needs is recommended.
- Policies should focus on integrating migrants (especially women) in productivity-enhancing ways; recently announced plans to ease quotas for immigrants are welcome, with salaries reflecting skills and qualifications across sectors and regions.
- Progress could be made addressing women’s underrepresentation in certain educational fields and occupations, supporting the recent decline in the gender pay gap.
- Access to finance, innovation, and administrative burden:
- Deepening the EU single market would leverage economies of scale, foster competition, lower costs, and enable innovative young firms to access finance more easily and grow.
- Further development of the Baltic capital market could help.
- National policies should support business climate improvements to attract foreign and domestic capital.
- Recent efforts to reduce administrative burden and red tape are welcome; expediting planning procedures and streamlining reporting requirements are important next steps.
- Building on measures incentivizing R&D spending, staff recommends fostering collaboration between universities and businesses.
- Expanding 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.
- Energy security and transition:
- Reliable connectivity and sufficient domestic production are strategic objectives for stable energy supply; 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 efforts to facilitate development of renewables and advocates boosting energy efficiency in the building and road transport sectors.
Key policy recommendations (selected)
- Implement a further moderate fiscal adjustment starting from 2026, totaling 0.5 percentage point of GDP per year during 2026-30 relative to baseline to stabilize the debt ratio at around 30 percent.
- Consider a comprehensive review of Estonia’s tax system to identify broad-based, growth-friendly revenue options and assess specific measures (personal allowance introduction in 2026, corporate tax regime, dividend taxation, property taxation).
- Preserve the commitment to contain public sector wage bill growth and limit exceptions to wage-setting rules.
- Establish a household income and asset registry to enable means-testing of social benefits and achieve cost savings.
- Review pension indexation mechanisms to avoid large one-off increases and potential inflation persistence.
- Maintain macroprudential vigilance: keep the countercyclical buffer at 1.5 percent, ensure proper risk weights across banks (especially IRB banks), and discourage large dividend payouts.
- Enhance AML/CFT implementation: strengthen ML/TF risk assessment and supervision of virtual asset service providers.
- Strengthen structural reforms to ease labor reallocation, reduce regulatory burden, deepen capital markets, expand venture capital and equity financing (including second-pillar pension fund involvement), and improve alignment of education with labor market needs.
- Continue efforts to secure energy supply, develop renewables, and boost energy efficiency.
Republic of Estonia: Staff Concluding Statement of the 2025 Article IV Mission (May 19, 2025).