The Ministry of Finance presented its summer economic forecast on Tuesday, giving both the Reform Party and Eesti 200 the basis to consider scrapping several previously planned tax hikes.

Prime Minister Kristen Michal (Reform) has said the government could drop the planned income tax increase set for next year, which was expected to bring more than €200 million into the budget. He also said the public sector could raise wages, which would cost nearly €100 million.

Kristina Kallas, leader of Eesti 200, said on Wednesday morning that her party will propose to its coalition partner that the vehicle tax also be abandoned. That would mean about €100 million less in revenue for the state.

ERR journalist Johannes Voltri asked Bank of Estonia economist Lauri Punga for his assessment of the government's proposals.

"If it is indeed true that this year's budget deficit will be smaller than previously thought, then even so, when we look at the forecasts for the coming years, there is reason to be worried about the long-term health of Estonia's public finances," Punga replied.

He stressed that next year's budget deficit will be a record-high of nearly 4 percent.

"Estonia's deficit has never been as large as it will be next year — nearly €1.8 billion. All of these additional proposals that we've been hearing about yesterday and today need to be seen in that context," Punga said.

The journalist asked where the problem lies, given that Education Minister and Eesti 200 leader Kristina Kallas said Wednesday morning that the country's borrowing capacity had significantly improved and that the government had put the budget in order.

"This is where we need to distinguish between the short-term outlook, how we're doing this year, and the long-term forecast — how things will look in the years to come," Punga said. "We are facing a very strong increase in defense spending, which will take a lot of money from the budget and also require borrowing. On top of that, there are several tax changes next year, which means less revenue for the state."

The economist emphasized that the budget will remain in deep deficit for the next several years.

"If we put all these decisions together and look at the long-term outlook, then what we actually see is that Estonia's public finances will remain in a large deficit for the next four years. A large deficit means debt will keep growing. With higher debt comes higher interest costs, and the faster debt grows, the fewer buffers we'll have in the future when we need to rely on that debt capacity in times of crisis," Punga explained.

The journalist noted that government representatives have said additional spending should be financed with borrowing in order to stimulate the economy.

"It's true that economic growth in recent years has fallen short of expectations. Time and again, forecasters have had to admit that recovery has been postponed. Even this year, in light of new figures, we see growth will not be as fast as previously thought," Punga said.

He added that while the economy has not grown in terms of constant prices, other indicators tell a different story. "We have many other indicators showing that the economy is not doing as badly, and that in turn makes it harder to answer the question of how much we should stimulate the economy right now and how much we should focus on keeping public finances in order given these new spending needs."

Punga stressed that the Bank of Estonia cannot tell the government which taxes to raise or lower, but it is essential that all new spending decisions included in the forecast are well justified and come with funding sources, so that the budget position does not worsen.

"As I said — there is reason to be concerned about the health of public finances. The deficit is set to grow sharply next year. Debt will continue to rise next year and we also need to keep in mind both European Union rules and domestic budget rules, which the government's fiscal policy must fit into," Punga said.

He pointed out that forecasts for tax revenues and the budget deficit in the coming years have not improved compared with the previous forecast. "On the contrary, they have worsened, since the new forecast includes the rise in defense spending as well as the altered content of the security tax," he added.

The journalist asked what the risk would be if the budget deficit continues to rise and remain very high in the coming years, and whether Estonia could fall into a so-called debt spiral.

Punga noted that the state budget has been in deficit for the past five years and government debt is nothing more than the sum of those deficits.

"We have an exemption clause for next year, which means we can spend a bit more than we previously thought, but with every decision in the coming years that increases the deficit, we have to keep in mind that we'll later need to start reducing it again and ideally move closer to balance in the long term," Punga said.

"All new decisions that further increase next year's deficit will only make that adjustment even harder," he added.

The journalist then asked whether, as an independent expert, Punga would recommend that the government avoid increasing the deficit further and instead refrain from additional spending and tax cuts.

"It is definitely important to stick to both domestic and European Union budget rules, which set the boundaries within which public finances must fit. The purpose of the exemption clause was primarily to increase defense spending, and once that exemption period is over, public finances must be brought back into good enough order so that this new level of defense spending also fits within the normal limits of state finances," Punga replied.

He added that from the Bank of Estonia's perspective, it is important that debt does not grow as fast as current forecasts predict.

"Because every decision that increases the deficit will later have an impact when we need to start reducing it again," he said.

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