The Estonian economy has experienced a relatively severe downturn compared to other countries due to disruptions in trade, weaker export demand, high inflation and tight monetary conditions. With improvements in external demand, growth should start to recover this year.

Estonian living standards have doubled since 2000 and income convergence was steady prior to the pandemic, although per capita GDP and productivity remain below the OECD averages.

Following a strong recovery from the pandemic, the Estonian economy has contracted since the start of Russia’s war of aggression against Ukraine in 2022 with GDP falling by 3.1% last year (Figure 1). Trade to the east was disrupted by the repercussions of the war, demand for Estonian exports in Nordic markets weakened, and household incomes were hit hard by the surge in inflation and a tightening of euro area monetary policy. Headline inflation has been falling rapidly in recent months, but core inflation has been more persistent. Exports have contracted, investment is below its pre-pandemic level and real consumption has been weak while households have drawn down pandemic savings and pension funds. A substantial negative output gap has opened up and the current account has swung into deficit. The labour market has held up well, but unemployment has started to rise. The financial system remains robust and non-performing loans are low, despite higher interest payments.

Growth will start to recover this year as prospects in Estonia’s main trading partners improve (Table 1). Initially, the recovery will be modest as high interest rates continue to weigh on consumption. With weak growth, inflation should ease to 2.1% in 2025, although the increase in the VAT rate this year and in excise taxes have brought a temporary rise. Risks to the outlook are tilted to the downside. Weaker than anticipated developments in export markets, a stronger housing correction or worsening geopolitical developments could complicate the recovery.

There is a budget deficit, but government debt remains low as a share of GDP.

Fiscal policy has provided support during the pandemic and the global energy price surge. At 19.6% of GDP, the government debt to GDP ratio (Maastricht definition) is the lowest in the OECD and debt dynamics are favourable.

The authorities announced a consolidation strategy for 2024-27. Due to worse than expected economic outcomes, the automatic stabilisers should be allowed to work fully this year, while considerable EU funds available for investment and upskilling programmes should continue to be used. Future consolidation should strike a balance between rebuilding fiscal buffers and supporting economic activity.

Last year’s budget deficit is estimated at 3.4% of GDP. Although a part of this reflects cyclical conditions, expenditures have increased in recent years due to higher spending on defence, healthcare and family benefits. Alongside the planned spending reviews, Estonia should review the tax system to explore avenues for increasing revenues in the medium term.

Given the low level of debt, the revised EU fiscal rules are likely to be less constraining on Estonia, which increases the onus on the domestic framework. The domestic budgetary rules have been strengthened, but the Fiscal Council has limited resources. The authorities should therefore strengthen the resources and analytical capacity of the Fiscal Council.

Given relatively high poverty, low-income households should be protected during the fiscal adjustment. Estonia’s overall tax burden is currently tilted towards labour and consumption.

Property taxation, considered economically efficient and the least damaging tax to long-run economic growth, remains very low. Long overdue revaluation of the land is being gradually phased in and will take place every four years. Municipalities should be given more autonomy to set the tax rates and, in the medium term, a recurrent tax on immovable property should be introduced.

The increase in long-term fiscal pressures due to ageing will be significant, although less than in many other countries. Other important spending needs include investment to accelerate the energy transition and to strengthen national security. To avoid additional fiscal pressures, the authorities need to develop a sustainable system to finance adequate retirements in the future and ensure adequate financing of better healthcare and long-term care.

Convergence in living standards with more advanced countries had slowed before the pandemic. Reversing this trend requires strengthening productivity growth by boosting digitalisation, innovation, and skills across all firms.

Despite an innovative ICT sector and pioneering digitalisation in the public sector, traditional sectors of the economy lag in digital technologies. To improve innovation, Estonia should continue enhancing cooperation between the public and private sector given that R&D spending, at 1.8% of GDP in 2022, remains moderate.

Although Estonia has a well-educated population and a high employment rate, the labour market has been marked by a structural skills mismatch and labour shortages. Almost 40% of workers are over‑ or under‑qualified and a lack of skilled staff has been a long-standing obstacle to investment. Management and organisational skills, key to the digital transition, appear to be a limiting factor and programmes for upskilling in managerial and digital skills should be broadened.

There is a narrowing but persistent gender pay gap. While women have high employment rates and parental leave can be taken by either parent, it is women who tend to take the leave and shoulder unpaid work in the household. Family policy spending is concentrated on cash benefits, while the offer of childcare services for children under 3 years old is limited. Childcare should be expanded and the ‘father quota’ in parental leave increased.

Estonia needs to strengthen understanding and management of the risks of corruption and money laundering in both the public and the private sectors.

Due to continued reliance on domestic oil shale and increasing emissions in several sectors, the Estonian economy remains carbon intensive. To halve GHG emissions by 2030 compared to 2005, decarbonisation needs to accelerate.

The EU ETS prices a large share of emissions and is set to expand, but effective carbon prices remain below most OECD countries. The carbon content of fossil fuels is not consistently taxed. Excise duties on fossil fuels are increasing but, to drive faster decarbonisation, policies should be more ambitious.

Domestic oil shale, the most important source of energy, has contributed to energy security, but accounts for around a third of GHG emissions and should be phased out as planned. The expansion of wind and solar energy has progressed but needs to go further. To accommodate renewable energy and switch to European standards, the electricity grid needs an upgrade.

With increasing reliance on cars, transport emissions remain above their 2005 levels. The car fleet is large and polluting. The introduction of new motor vehicle taxation planned for 2025 is welcome. It could be accompanied by a scrappage scheme to support low-income drivers. With 40% of the population living in and around Tallinn, expansion and further decarbonisation of public transport is needed.

Health and life expectancy have improved significantly over the past two decades. However, years spent in good health are still among the lowest in the OECD. The health system is well designed but there are areas for improvement. Avoidable mortality is high as heart disease remains prevalent and cancer mortality rates elevated. Outcomes for older men and people on low incomes are particularly weak and there are significant regional disparities.

The financing of the health system is under pressure. Achieving further improvements in health outcomes against the background of an ageing population will likely require additional funding, while ensuring that spending remains efficient. Moreover, the authorities should consider sustainable funding models for long-term care, using a combination of public and private funding, while ensuring benefits are based on both income and needs.

Public health insurance covers the vast majority of the population, but there are gaps in coverage and high out-of-pocket expenses for medicines and dentistry. A universal system would close gaps in coverage at a relatively low cost. There is scope to reduce co-payments and better target support for low-income households for dental care and pharmaceuticals.

The health system provides good incentives for the use and allocation of resources. Nevertheless, there is room to improve treatment, increase the size of performance-linked payments, prioritise resources and exploit other efficiencies. Improving competition in the pharmaceutical market through easing restrictions on retail pharmacies and more use of joint medicine purchases by hospitals could lower medicine prices. Digitalisation is advanced but should be exploited further by making better use of existing information for monitoring and analytical purposes.

Persistent shortages of doctors and nurses complicate treatment and prevention and difficult working conditions contribute to staff shortages. Many doctors, notably in rural areas, are close to retirement. There is competition for medical staff from neighbouring countries, but few foreign medical staff work in Estonia. Wages of medical staff increased considerably in 2023. Measures to address shortages of doctors and nurses should ensure pay remains competitive, include more training, for instance by raising the number of places in nursing colleges and medical school, and improvements in working conditions.

To further improve health outcomes, broader cancer testing and improved awareness among the low income and less educated population is needed.

Given the prevalence of obesity and poor nutrition among some population groups, the proposed sugar tax should be implemented and taxes on unhealthy food introduced more generally.