Economic development in Estonia

Ministry of Finance, Estonia

Tight budgetary policies have been part of the foundation that helped Estonia achieve stability and growth of economy. The cornerstone of the budgetary policy is the fundamental decision not to allow any central government borrowing from the Central Bank; conservative foreign borrowing is connected only with capital expenditure. The budgetary policy can be briefly summed up as follows.

Due to strict budgetary discipline, inflation (measured by consumer price index) has not become a direct constraint to economic growth and employment.

Support to private sector development, liberal economic policies, rapid privatisation, a simple tax system with low rates and a swiftly developing banking sector have created good prospects for future low inflation development.

Despite continuing trade balance deficit and high inflation by European standards, trust in the Estonian kroon and the development of its economy is growing. This may be proven by capital inflow, volume of per capita direct investment, growing foreign exchange reserves and real effective exchange rates.

Despite unfavourable starting conditions in the country's transition to the market economy, eg, low income levels and purchasing power, an ageing population and the resulting relatively high social costs, marked contraction of traditional markets for agricultural products, and large investments needed for the infrastructure, Estonia has made a conscious effort not to build up large debts.

The Estonian Government has restrained the expenditure to available revenue. Ratio of state taxes to Gross Domestic Product (GDP) has been at the level of about 36 per cent, non-tax revenues and property income about two per cent and general Government expenditures about 39-40 per cent of GDP in recent years. Tight fiscal policy has been aimed towards price stability and increase of domestic savings. The overall deficit appeared in 1995 and 1996 (1.2 per cent and 1.5 per cent of GDP). Due to the favourable developments during 1997, general Government deficit has turned into surplus, preliminary estimated at 1.5 per cent of GDP amounts to 1.5 per cent in 1997. This leaves sufficient room for securing the stability and growth of the Estonian economy should negative tendencies emerge.

Rapid privatisation and quick development in the banking sector have been the economic cornerstones for further growth and stability. Today 89.5 per cent of the registered enterprises belong to private owners, including all the banks. The banking sector development may be characterised by the volume of the consolidated balance sheet of commercial banks, which has increased about seven times in five years.

At the same time, with the continuously strong performance of the economy, the current account deficit has been increasing, reaching a level just below ten per cent of GDP in 1997. Although analysis of the foreign trade statistics show that substantial share of imports are capital goods, machinery and equipment, this is the most critical problem that the Estonian economy is facing today: mobilisation of resources to support the growth of export both in qualitative and quantitative terms.

Nevertheless, the impact of the import of capital goods, even if expensive for the economy as a whole, is crucial. It can be alleviated through the increase of productive capacities, labour productivity and medium-term exports. Since 1993 the inflow of foreign direct investments (FDI) into the Estonian economy is about 16.7 billion EEK, ie, slightly more than US$800 per capita. Economic agents acting both in the public and private sector do not share doubts that the foreign trade deficit could reach unsustainable levels, or that the exchange rate will not hold firm.

By total volume of FDI per person, Estonia is in second place among the Central and Eastern European countries, just before the Czech Republic. However, in comparison with more successful countries of the region and of the world, one can see that there is still much to be done. Taking this into account, a goal for the next five years has been envisaged to accelerate economic development by doubling the volume of FDI. Investment projects involving high technology and capital intensity, export oriented projects and projects enabling the creation of modern jobs are given preference.

FDI to Estonia mainly originates from the neighbouring states, such as Sweden, Finland and Russia. Sixty per cent of all FDI come from these countries. The prevalence of capital from neighbouring states may be explained by their better knowledge of processes underway in Estonia, along with better access to information, and their former experience of co-operation with Estonian businesses. The share of the world's five major investors (USA, Great Britain, Japan, Germany and France) in the structure of Estonia's foreign investment is considerably smaller than it could be, presumably because of unavailability of adequate information.

From 1 January 1998, the outstanding debt of the general Government was 5.4 per cent of GDP. Estonia continues to pursue the policy of modest foreign borrowing, to avoid a possible drain on the state budget resulting from foreign debt servicing. The Government has prepaid some foreign debt with unfavourable maturity structure, so that there are no peak years in debt service.

Preliminary estimates of the economic results for 1997 indicate economic growth of more than 9.5 per cent and the Consumer Price Index (CPI) annual increase of 11.2 per cent (compared to four per cent real growth and 23 per cent CPI increase in 1996). As a medium-term target, the GDP is expected to grow by five to six per cent over the next three years. Such growth is seen as sufficient to accommodate the adjustment of prices to world market levels and to maintain the downward trend of inflation. Given the success in stabilisation to date, and by closely monitoring the expansion of costs, we can expect the growth to continue and inflation rates to drop to levels below five per cent in the medium-term perspective. Continuing direct investment inflow and increasing labour productivity are important pre-conditions to achieve this goal.

Estonia meets the modern understanding of a prudent but efficient country that ensures social justice as best as it can. It does so by remaining true to a strict budgetary discipline, and by pursuing principles that were developed during the first period of independence. The Memorandum of Economic Policies approved by the Board of the International Monetary Fund (IMF); the decision by the Council of the European Union to begin negotiations with Estonia about the conditions of joining the European Union (EU); investment grade ratings given by the rating agencies - Moody's 'Baa1' and Standard & Poor's 'BBB+' are proof of the growing confidence which international financial and economic organisations have in Estonian economic development.

The Estonian financial system is based on modified currency board principles - currency and deposits in the Central Bank are completely backed up by gold and convertible foreign currencies (called reserve currencies). Meanwhile, a fixed exchange rate with the DM and teha guaranteed conversion of the national currency. The Bank of Estonia cannot devalue the kroon without an appropriate decision by Parliament. This arrangement lessens the danger that the exchange rate policy might become an object of short-term economic or political pressure.

The tax policy of Estonia is aimed at implementing as neutral a tax system as possible, to promote further the development of market economy and to attract investments. The Government policy is to retain the current tax system without changes, in order to maintain economic stability. As for direct taxes, a unified and proportional income tax rate will be maintained. The share of indirect taxes in tax receipts will gradually grow according to the adjustment of excise tax rates.

There is a unified 26 per cent income tax rate established in Estonia for both local enterprises and physical persons, as well as for non-residents. Provisions enacted with the Law on Income Tax apply to income derived from sources located in Estonia. Whenever the Estonian laws are in conflict with international agreements which Estonia has joined, the provisions of the international agreements shall generally apply.

Estonia has concluded bilateral investment promotion and protection treaties with 19 countries: Austria, Belgium, the Czech Republic, Denmark, Finland, France, Germany, Israel, Latvia, Lithuania, Norway, China, Poland, Sweden, Switzerland, the Netherlands, the Ukraine, the United Kingdom, and the USA. Also signed and awaiting enforcement are similar agreements with Greece, Italy, Spain and Turkey.

Double income and capital taxation avoidance and tax avoidance treaties have been concluded with 12 countries: Canada, the Czech Republic, Denmark, Finland, Iceland, Latvia, Lithuania, Norway, Poland, Sweden, the Ukraine, and the United Kingdom. Treaties with Germany and the Netherlands have been ratified, but are not yet in force. In 1998 negotiations will begin for concluding similar treaties with Cyprus, Georgia, Malta, the Slovak Republic, Spain and the Republic of South Africa. Negotiations begun earlier with some other countries will also continue in 1998.

Free trade agreements with the EU, EFTA, the Czech Republic, Latvia, Lithuania, Norway, the Slovak Republic, Slovenia, Sweden, Switzerland and the Ukraine have also been concluded in order to promote foreign investment.

Following the Law on Foreign Investments, foreign investors have equal rights and obligations with local businesses in Estonia. Foreign investors have the right to purchase land and derive use from it, repatriating profits after tax without restrictions on foreign currency earned from foreign enterprises.

Licence is required for investment in the following areas of activity: the mining industry;

  • energy, gas and water supplies;
  • reconstruction and expansion of railway and air transport, expansion of water transport ways, ports, dikes and other hydraulic structures; telecommunications, maintenance, expansion and reconstruction of communication networks;
  • retail sales of pharmaceuticals;
  • production of alcohol and tobacco products;
  • banking services and gambling.
The management of enterprises with foreign participation shall comprise 50 per cent of residents in Estonia.

In line with the national regional policy, investment in regions determined by the Government of Estonia as regions of priority development are exempt from income tax. Those entrepreneurs who have taxable profits and whose businesses are located in the regions of priority development, and those who have acquired and improved Depreciation Group 1 assets, or installations for entrepreneurship in the said regions during taxation period, are offered income tax benefits. The above mentioned regions include all local government units of Estonia, besides the capital Tallinn and eight local government units located in its vicinity.

Table 1: Foreign direct investment in Estonia, 1992-1997 (DM):

Aasta 1992 1993 1994 1995 1996 1997 (Q.1-3)
DM, million 137.5 258.9 352.4 289.1 241.0 398.5
DM, per person 93.1 175.4 238.8 195.9 163.3 269.9

Table 2: Foreign direct investment, 1993-1997 (million DM) Breakdown by basic components

Components 1993 1994 1995 1996 1997 (Q.I)
Total FDI capital 248.6 348.7 285.5 166.2 109.5
Invested abroad -10.3 -3.7 -3.6 -60.6 -25.4
Invested in Estonia 258.9 352.4 289.1 226.8 134.9
Incl. in fixed capital 144.1 234.7 144.0 25.5 30.1
Incl. in new enterprises 95.5 79.9 24.4 6.1 0.4
Into operating enterprises 48.6 154.8 119.7 19.4 29.6
Reinvested profits 44.6 68.8 22.3 27.0 80.1
Loan capital (net) 69.1 47.2 121.1 172.8 24.3
Incl. claims to direct investors -10.2 -8.1 -7.6 -19.7 18.8
Incl. liabilities before direct investors 79.4 55.3 128.7 192.5 5.5
Other investments 0.0 1.7 1.7 1.5 0.4

Table 3: Foreign investment related agreements of the Republic of Estonia

Country Investments Promotion and Protection Treaty Double Taxation Avoidance Treaty Free Trade Agreement
Austria +
Belgium +
Canada +
China +
Czech Republic + + +
Denmark + +
EU +
Finland + +
France +
Germany +
Iceland +
Israel +
Latvia + + +
Lithuania + + +
Netherlands +
Norway + +
Poland + +
Slovak Republic +
Slovenia +
Sweden + +
Switzerland +
Ukraine + + +
United Kingdom + +
United States of America +

Top | Estonia