Estonia
Economic growth will remain solid, but slow to 3.7% in 2018 and 3.2% in 2019 as labour resources become scarcer. Private consumption is projected to strengthen, boosted by personal income tax reductions and wage growth. Investment is projected to continue to support activity. Improved euro area growth will stimulate exports despite increases in unit labour costs.
The fiscal stance is broadly neutral in 2018 and will be mildly expansionary in 2019. While this is appropriate given accommodative euro area monetary policy, fiscal space is available to foster inclusive growth and address societal issues once risks of overheating ease. Measures to support innovative activities in domestic firms and improve access to lifelong education should be prioritised.
An investment recovery is boosting growth
Economic activity maintained a strong momentum in the second half of 2017. GDP growth is broad-based with notable contributions from construction and ICT sectors. Private and public investment have recovered firmly on the back of increased disbursement of EU funds. Improving consumer confidence points to a pick-up in private consumption after its relatively low contribution to growth in 2017. The unemployment rate has fallen well below its estimated structural level and labour shortages are starting to spread. Accelerating labour productivity is closing the gap to real wage growth. Exports have recently regained momentum after a sharp drop in mobile equipment exports in 2017.
Tax reforms are supporting demand
Fiscal policy is projected to be broadly neutral in 2018 and mildly expansionary in 2019, as the government’s budget strategy targets structural balance over the next four years. Strong economic activity will boost taxes and generate a budget surplus in 2018 as government consumption growth is curtailed. Spending pressures from ageing will intensify in the medium term and shift spending towards transfers and health care. Nevertheless, decreasing and very low public debt leaves ample scope to step up public expenditure on measures to boost growth potential and welfare, notably by enhancing incentives for labour market participation of mothers and promoting skilled immigration.
In 2018, changes to the tax system are shifting taxation further away from labour to consumption. Progressivity in the personal income tax system is being introduced by significantly increasing the tax-free allowance for low incomes. While this is welcome, the inequality-reducing effect of the tax and transfer system remains weak. The corporate tax rate on distributed dividends is being reduced to improve the business environment. While this is expected by the authorities to generate a spike in tax revenue in the short term by encouraging companies to distribute profits, it will decrease revenues in the longer term. Combined revenue effects from the tax changes are uncertain and should be carefully monitored.
Potential growth over the medium-term is constrained by a shrinking working-age population and still weak productivity growth. The ongoing implementation of the Work Ability reform is expanding labour supply, but is also expected to increase unemployment moderately in the coming years as it brings increasing numbers of people with reduced work capacity into the labour force. Strengthening the quality of adult education and co-operation between the private sector and public R&D institutions would enhance innovation and productivity.
Growth is projected to decline as the economy reaches full capacity
Growth is projected to decline to a more sustainable pace. Headline inflation is expected to flatten out as the effect of excise duty increases fades. It will nevertheless stay well above the euro area average as the labour market tightens. Strong domestic demand will lift imports partly due to a relatively high import content of investment. An upside surprise in euro area growth would boost exports. Conversely, prospects are clouded by geo-political risks. Intensified labour shortages could also stoke wage pressures and undermine competitiveness.