Changes to income tax will leave people with more take-home pay, while an increase in government spending will inject additional money into the Estonian economy, the central bank said Friday. Lower interest rates, continued access to bank loans and slowing inflation are also contributing to a more positive outlook.

In 2026, Estonia's economy is forecast to grow by 3.6 percent, but as fiscal stimulus fades, growth is expected to slow to 2.5 percent by 2028.

The general government budget will fall into a significant deficit next year.

"Excluding the pandemic-era shortfall in 2020, next year's deficit will be the largest in the last 30 years," the Bank of Estonia said.

"The main reasons for the worsening budget position are the reform of the income tax system and defense spending rising above 5 percent of GDP. A notable share of these expenditures will go toward imports and therefore will not stimulate the domestic economy," the central bank noted. "Based on currently available information, the deficit is expected to remain substantial throughout the forecast period, through 2028."

In the short term, lower taxes and higher government spending will help boost growth. However, this also means the state's debt burden and annual interest expenses will continue to rise.

By 2028, Estonia's public debt is expected to reach 31.5 percent of GDP, while annual interest payments are forecast to hit around €400 million — double the amount in 2025.

"The longer the restoration of fiscal balance and the stabilization of public debt are delayed, the more difficult it will become. Moving toward a balanced state budget would temporarily slow economic growth," the bank stated.

Inflation is expected to slow over the coming years. By early 2026, the inflationary effect of the planned motor vehicle tax will fade and, by mid-year, the impact of last year's VAT hike will also drop out of the annual comparison. At the same time, falling food commodity prices will be reflected in retail prices, bringing an end to rapid food price increases.

"The previously rapid rise in service prices will be moderated by slower wage growth. Although the increasing fiscal stimulus and related surge in domestic demand will generate added inflationary pressure, this will be offset by faster productivity growth and businesses' ability to raise prices more slowly than their input costs," the bank predicted.

Consumer price growth is expected to slow from 4.9 percent in 2025 to 2.9 percent in 2026 and 2.4 percent in 2027.

The labor market outlook is favorable amid rising economic activity. Since businesses did not cut staff as quickly as production during the downturn, they will initially be able to ramp up output without significantly increasing hiring. Employment is expected to grow slightly in 2026 and then remain relatively stable, the Bank of Estonia said.

Unemployment is set to decline gradually, mainly due to a shrinking labor supply rather than job growth. Population aging will reduce the number of active participants in the labor market, though the overall participation rate will remain high by both historical and international standards.

The growth of average gross wages is expected to slow, but changes to the income tax system will lead to a sharp increase in net income. In 2026, average net wages are projected to rise at roughly twice the pace of gross wages — about 10 percent — as a result of the legislative reform.

"Thanks to slowing inflation, people's real purchasing power will improve significantly. At the same time, the income tax reform will reduce cost pressures on employers and help restore profitability, which has suffered in recent years," the central bank noted. "Labor costs as a share of value added have risen to near-historic highs in recent years and a reversal in this trend — i.e., restoring profit margins — is a key condition for improved investment capacity among businesses."

Loan borrowing and repayment costs are expected to remain favorable for borrowers. While further changes in the Euribor rate are expected to be minor, the recent decline combined with banks' continued lending capacity will support both companies and households.

Unlike many euro area countries, most loans in Estonia are tied to the short-term six-month Euribor, with a relatively small share having longer fixed interest periods. As a result, interest rate cuts by the European Central Bank have reached Estonian borrowers more quickly and this will continue to support the economy in the coming years.

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