OECD: Estonia's economic growth held back by war, high inflation

TALLINN – According to the Organization for Economic Cooperation and Development (OECD), Estonia has done well handling the economic shocks caused by the pandemic and is expected to see continued economic growth, whereas risks to the outlook for the economy are posed mainly by the war initiated by Russia and high inflation. 

In its economic forecast on Estonia published on Tuesday, the OECD says that while the Estonian economy recovered to the pre-pandemic level in 2021, in the future this trend will stop due to the war initiated by Russia in Ukraine

"After a very robust expansion in 2021, GDP growth is expected to slow to 1.3 percent in 2022 and 1.8 percent in 2023, owing to the war in Ukraine. Household purchasing power is suffering as inflation far outpasses nominal wage growth. Export opportunities are expected to shrink, which, together with reduced confidence, will weaken investment," the OSCD said.

It said the gradual drawdown of savings accumulated during the pandemic and in individual pension funds, as well as the inflow of EU funds, will support the economy. Unemployment is expected to increase, as a large number of refugees are entering the country and not all of them are likely to find jobs immediately.

Economic growth will be supported by the deployment of euro funds and the Recovery and Resilience Facility. However, the outlook for growth is under threat from high inflation, driven by food and energy prices.

The OECD notes that interest rates are too low to tame Estonia's high inflation, thus making it important to tightly target fiscal spending to refugees and the most vulnerable, building defense capacity and investing in energy infrastructures, to avoid stoking inflationary pressures further.

The strong rebound in activity is amplifying the lack of suitable labor despite unemployment, underscoring entrenched skill mismatches. Pandemic-induced stricter border controls and administrative hurdles have also led to a lack of foreign workers to help fill the gap, notably in the digital and construction sectors.

According to the OECD, there is room to make anti-poverty transfers more effective and better targeted in Estonia. Introducing in-work benefits, which currently do not exist, could reduce 

poverty while making work pay more. Reducing employees' social security contributions for low wage earners would also reduce poverty by strengthening employment, notably for low wage earners and young workers. 

Estonia's gender pay gap remains one of the highest in the OECD, despite progress in recent 

years. In this context, the OECD recommends that the amendments reinforcing the implementation of the equal pay principle that were abolished in 2019 should be re-introduced.

To prepare for future challenges -- notably climate change and ageing -- tax reform options that do not jeopardize the efficiency of the tax mix could be discussed. In the long term, population ageing will increase health and pension spending. Reducing carbon emissions and adapting to climate change will require more public investment. One option is to review the taxation of corporate income, which is among the lowest in the OECD.

In particular, Estonia could examine the benefits obtained from the preferential 14 percent corporate tax regime granted to companies that distribute dividends regularly. This new regime should be evaluated to assess its merits regarding investment and entrepreneurship, 

compared to its cost. Furthermore, Estonia could discuss whether the new land valuation, to be carried out in 2022, is an opportunity to also evaluate the stock of housing and business properties and then expand the property tax base beyond land.

Estonia has a relatively carbon intensive economy among OECD countries. Oil shale is prevalent in Estonia’s energy supply although the share of renewable energy has been consistently rising. Highly concentrated in the north-eastern region of Estonia, the oil shale industry is being gradually phased out. This transformation will have a significant economic and social impact on the East-Viru region, which the government seeks to mitigate with good governance, targeted active labor market policies, income support and strengthened regional development policies.

Public investment in research and development, focused on more environment-related issues, should be increased and the deployment of new and innovative low-carbon technologies in 

the private sector should be supported, the OECD finds.

The data on which the recommendations are based have been collected in the main part before Russia's aggression against Ukraine, which may be why, according to the Estonian Ministry of Finance, some of the recommendations may need to be reassessed.