Temptations of a Pre-Election State Budget October 16, 2014

Raul Eamets 
Chairman of the Fiscal Council

The global economy is going through difficult times, with the crisis in Ukraine, the events in Syria, and the disappointingly weak performance of emerging economies. These stories are constantly in the news in countries that are having to correct their economic forecasts downwards, just as Estonia did this year. As far as the economy is concerned, we are not standing on solid ground. 

However, the debt burden of the Estonian public sector is the smallest in Europe by some margin, and the government sector budget has generally been in surplus over the last 15 years.

This gives the government greater freedom of choice in the event of any emergency, and allows it to follow a stable budgetary policy that everyone can predict and rely on. The experiences of other European countries show that achieving and maintaining this strong position is not easy.

Higher tax revenues and generous borrowing terms make it more tempting to spend more during good times, but the European debt crisis sounds a warning about this. To ensure the sustainability of public finances and to prevent a crisis like that in Greece from recurring, the member states of the European Union agreed on rules to guarantee balanced government sector budgets. Estonia's budget for the coming year will be the first to fit into this new framework.

The budget rules provide clearer objectives for planning budgetary policy. After the recession of a few years ago, real GDP growth in Estonia has been between 1.6% and 8.3%, while tax revenue has grown consistently by between 5.5% and 8%.

Even so, the government sector budget has been slightly in deficit to the tune of up to 0.5% of GDP since 2012, and this balance has not shown signs of improving for many years now. The new State Budget Act sets out the minimum target for the budget and requires the government sector budget to be in structural balance at the least. This requirement serves as a starting point for the 2015 state budget.

The requirement for structural balance says that the government sector budget must be balanced across the economic cycle, meaning the government should not spend all of its income during the good times but may allow some spending, notably on social security, to grow during more difficult times.

The structural balance indicator for the budget strips out the impact of the economic cycle and all sorts of extraordinary revenues and costs, allowing for a better assessment of the actual state of the public finances. This indicator also takes a central role in the European Union framework.

Although the idea of a strategic budgetary balance is attractive in theory, it can be difficult to translate into specific targets as there are several equally valid methods for assessing the state of the economic cycle, and the different methods can generate quite different results.

To help them stick to a rule-based budgetary policy, the member states of the European Union decided to create independent Fiscal Councils, and the Fiscal Council of Estonia was set up this spring.

The Fiscal Council of Estonia has so far given opinions on how the targets for the structural budget position were met in 2013, and on the summer economic forecast of the Ministry of Finance. In this opinion the Council emphasised that the estimate for the 2015 structural surplus might be too high.

This is why we do not see the structural surplus of 0.8% of GDP that is given in the explanatory note to the draft budget as sufficient to allow for retrenchment if it becomes necessary.

The state budget plan for the next year is not a plan designed for difficult times, and tax revenue is expected in the 2015 state budget to grow by 6.1%.

The planned tax revenue follows the summer economic forecast of the Ministry of Finance, which predicts that the more highly taxed components of GDP will grow more rapidly than the average, while tax receipts will be further boosted by efforts to make tax collection more efficient.

Tax revenues for 2014 and 2015 are forecast to be very good indeed compared to the forecast for real GDP growth. There is every reason to ask whether some part of this revenue is a temporary revenue surplus, and this means that there is no absolute certainty as to whether the 2015 draft state budget which is currently under discussion would give any structural surplus at all for the government sector. Sadly, we will only know for certain afterwards.

Another concern is the excessive optimism about EU funds. As we know, the deadline for using the funds from the previous EU budgetary period ends in the middle of 2015, and earlier experience suggests it might be slightly naive to hope that the funds of the new period will become available at exactly the same moment. However, this is not very important for the budgetary balance because the EU funds will appear in both the revenue and spending columns.

Given all this, it would be somewhat irresponsible to assume or hope for even larger tax revenues based on the economic forecast that serves as the basis for this budgetary plan.

Although the upcoming elections may make members of the parliament anxious to direct additional funds to various regions or favoured activities, it is important to remember that any rises in spending are only possible if spending is cut elsewhere. Only then can we avoid the risk of the government sector budget for next year breaching the legal requirement to be in balance or in surplus.

Published: 10 October 2014
By: Postimees