Heldur Meerits: What should be taken into account to sort out the state budgetary mess? | Notice

There was a time when city dwellers went to the countryside to help with work. If this practice was reminiscent of the traditional way of life, it was mainly because the kolkhozes and state farms did not live up to expectations. In any case, agricultural organizations could not have improved much within the system; the only realistic solution was to lower expectations. But this did not help people lose their eating habits. Of course, the Soviet version of clientelism did not solve these problems, although it may have alleviated them somewhat.

The government’s inaction and indecision raised eyebrows for almost a year. The drama culminated last week when it emerged that Kaja Kallas was set to secure the coveted post of top EU representative.

This seems like a perfect win-win situation. On the one hand, she will get a job to her liking where she can benefit both Estonia and Europe. On the other hand, the government will find itself blocked, certain decisions having been postponed for too long.

Over the past year, Estonia has accomplished almost nothing to resolve its budget deficit. We have only borrowed more and increased our interest obligations during this period.

Finding solutions is not a matter of pressing a button and requires, in addition to government decisions, a broader public debate – so that citizens accept the choices to be made, at least at some level. The aim of this article is to sketch out some lines, in the spirit of such clientelism, that should be kept in mind in order to untangle the knot of problems that is the state budget.

When working on a budget strategy, it is usually helpful to understand where it is in the economic cycle. This should determine whether the budget should be in surplus, deficit, or even balanced. At least, that is how it would be in an ideal world.

In the current situation, the threat of war is paramount. War would take tens of thousands of people away from their daily work. Minor or major damage to infrastructure would also have to be expected.

Probabilities are worthless in war. Whether it is one, five, or 10 percent, you can toss a coin a hundred or a thousand times, but you only have one life to bet on. Therefore, as long as the probability of war is greater than zero, it must be considered a possibility.

War is also a situation in which sooner or later you have to invest all your resources, especially your money. In the budget context, this means the ability to borrow more money.

We certainly have reasons to rely on our EU and NATO allies, but we must nevertheless maintain a certain autonomy in decision-making. This means an independent ability to raise funds. In times of war, borrowing money on market terms is extremely complicated. For example, investors expect a 60% yield on three-year Ukrainian bonds.

All the more reason to try to convince investors that Estonia can maintain fiscal discipline and control.

Our public debt is not too bad, and there is room to borrow more if things go wrong. But things are much more complicated when it comes to current expenditure and revenue. Here, our capacity is much less. We can simply stay within the (EU) criterion of 3% of GDP this year, while the budget deficit is on track to exceed 5% next year, unless we act.

Let us also remember that these figures concern the GDP deficit. If we simply look at income relative to expenditure, we spend almost 10% more than we receive. This does not look particularly good to investors anymore. And they do not really care about explanations that countries cannot go bankrupt. The recent example of Greece is a powerful reminder that some private debt can simply be written off. We should even avoid thinking that Estonia could become the next Greece.

The above should make it clear that Estonia should not allow its budget deficit to exceed 3% of GDP without extraordinary and very valid reasons.

But there are other considerations to take into account besides the war cycle. Chief among them is the examination of the current state of the economy. The principles of countercyclical logic should be well known: spend more in times of crisis and less in times of expansion. This approach is generally justified by the need to influence the pace of growth. However, we have reason to doubt the effectiveness of this approach in the context of Estonia (and other countries with small and open economies).

In addition to budgetary expenditures, the money supply is also influenced by export success and bank credit conditions. These factors can have different effects, although changes in budgetary expenditures are not necessarily the most important factor, even when it comes to amounts.

Instead, we should seek to maintain stable spending, regardless of revenue surpluses or shortages.

Analysts are not in complete agreement on the current position of the business cycle. Real growth has been negative for nine consecutive quarters, but it is questionable whether the statisticians used the right deflator and whether the price progression calculations are correct. Real retail turnover is falling, while employment remains high and wages continue to rise. This last point is perhaps linked to the aging of the population and does not reliably describe the economic phase. In summary, we should be able to afford a small deficit depending on the economic cycle.

So, if we want a small deficit (e.g. 0.5 to 1 percent of GDP) for the coming years, we should thoroughly review the expenditure side of the budget.

On the one hand, defence spending is increasing and it seems impossible to reduce it to 2% of GDP in the near future. Spending €1.6 billion on munitions – even if it is spread over several years – will probably not be the last necessary expenditure. Now, if we think about a reasonable deficit, it is obvious that we will have to reduce our spending elsewhere. And it would be wrong to blame defence spending.

On the contrary, we have been too quick to spend in recent years. The largest budgets are those of the Ministry of Social Affairs (7.2 billion euros this year), the Ministry of Climate (1.2 billion euros), the Ministry of Economic Affairs (1.4 billion euros euros) and the Ministry of Education and Research (1.1 billion euros). This suggests that austerity should also be most radical in this country.

We must always make sure we can afford to fund our state. There are always many ideas and it is difficult to realize them. It is almost a given that life gets better from one year to the next. But no natural or economic law guarantees that a person’s standard of living must continue to improve.

Yes, people would like us to have the resources to achieve our dreams. Political logic leads parties to try to outdo each other before elections. And all these promises cannot be kept after the elections, and at least some of them will have to be kept. This is a major flaw in democracy that organically leads us towards a perpetual budget deficit.

In the meantime, the reality is that population aging and decline will begin to erode our well-being, slowly but surely. A quick comparison between the United States and Europe is enough to confirm this.

Some sometimes try to brush aside fiscal concerns. Some argue that countries never have to repay their loans, which is a naive view at best. Even if the principal amount of the loans remains unchanged, the interest must still be paid. And very few loans are for life. Most loans have an end date, the arrival of which requires at least refinancing. While the conditions for granting new loans can only be guessed at.

A milder version of the same approach is to talk about “overextended lending.” Indeed, if the loan amount stays the same while the economy grows, arithmetically speaking, the loan-to-GDP ratio improves. However, this only works if you don’t take out new loans. In reality, it’s too much to hope that politicians will be able to overcome the temptation and maintain balanced or even surplus budgets.

When it comes to balancing the budget, another temptation is to raise taxes. In a situation where the total tax burden in Estonia is 34 percent and in Sweden 44 percent, this seems almost a natural solution. However, it is easy to confuse cause and effect here.

Those who mock the path to prosperity through taxes are right. Sweden’s GDP per capita was €44,600 in 2023. It was €15,400 in Estonia, a difference of 2.9 times. If we take into account the tax burden, after taxes, individuals and companies were able to keep €25,000 in Sweden and only €10,100 in Estonia. While the tax increase has slightly reduced the gap, the difference is still 2.5 times.

Therefore, higher taxes will not bring us wealth, income can increase through better productivity and investment in businesses. Once you have enough income, you will have something to tax.

We must hope that the new government will not look at the world through rose-colored glasses, that it will accept our realistic limits and that it will refrain from trying the tricks of Baron Münchhausen. The situation is difficult, but it is possible to get back on firmer ground by making the right decisions one after the other.

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