From Q1 2022 onwards, Estonia has been in a prolonged recession. Yes, we also had a recession last year, but—rare in our history with Estonia—we have overcome it and are moving on. We are moving, but Estonia, for some reason, is not, Janulevičius states. So, what has happened?
The outbreak of the war in Ukraine is, of course, one of the reasons for Estonia’s economic difficulties during this period, but demand problems in its main export markets (the country is heavily dependent on exports to the Scandinavian countries, which have experienced a bit of a “surprise”, as even in Sweden there is a possibility of a recession), the loss of raw material imports from Russia (as a result of the moral implementation of the European Union’s sanctions on the country), and now the decline in investment have all played an important role here. Lithuania has faced most of these problems.
How was Latvia doing at this time? Just as Vilnius does not like to compare itself with Kaunas, Lithuania does not like to compare itself with Latvia. It is also doing worse than Lithuania is doing now. And there is nothing to be happy about. Just as in the recent Baltic Way, we are all better off when we are strong together.
Let us return to Estonia. Estonia’s quarterly recession, which began in the first quarter of 2022, continued until the first quarter of this year. And it was only in the second quarter of this year that the first economic growth of 0.7% was recorded after this long economic dip.
At the same time, the Lithuanian economy has been growing over the last two quarters, albeit not very smoothly. In the second quarter of this year, it grew by as much as 3.5%, which is also an excellent result for the European Union as a whole: in the European Union, the economy grew by just 1.3% in the second quarter.
2023 Estonia’s economy shrank by as much as 3.0 per cent, while Lithuania’s shrank by only 0.3 per cent. This year, even though a recovery of the Estonian economy was expected at the beginning of the year, the economy will shrink again, but less. The economic contraction is forecast to be 0.5%, while Lithuania is expected to grow positively.
What is saving the Estonian economy, at least a little? So far, public investment has been the engine of the economy. Private companies have had no good news this year and will continue to cut back on investment as they face significant problems with demand from domestic and export markets. So, for the time being, only workers in Estonia are “celebrating,” with wages continuing to rise and interest rate cuts already underway.
Although the Estonian economy is in this situation for several reasons, who could deny (and more than one economist has pointed this out) that its economic growth is also slipping this year because of the tax reform that is being carried out, which will see the VAT increase from 20% to 22% at the start of this year and personal income and corporate taxes increase from 20% to 22% from 2025. And that’s not all. VAT is proposed to increase to 24% from July 2025 and personal income tax to 24% from the beginning of 2026. A temporary defence levy of 2 percentage points for corporate tax will be introduced from the beginning of 2026 until the end of 2028. It will be up to the successive governments to decide whether that defence levy should be maintained after 2028 or abolished.
Perhaps not wanting to repeat Estonia’s fate, Latvia has decided to halt its tax reform, which proposed increasing VAT and personal income tax progressivity.
The Baltic budgets desperately need additional funds to finance the defence sector. But our neighbours’ examples more than clearly show that ill-considered tax reforms, which cut through growth opportunities and immediately worsen consumer sentiment, start to sink the entire national economy and, therefore, GDP. I will not tire of repeating that defence benefits less from lower GDP. Then, the new tax equilibrium starts again, damaging both business and consumer confidence. And the trap closes.
What can we do to avoid falling into that trap? Geopolitical challenges in our region are no longer extended challenges but permanent geopolitical states. We have to invest in our own security first. However, it is more important than ever that the sources of funds for such investments are well thought out and that any changes and reforms are measured, assessed, and debated.
Once again, business taxes are not a bag to be drawn from as and when needed. A careless hand can usually leave a massive hole in the bottom. It is good that we did not do that a year ago, and our poorly drafted tax reform went into a drawer. That is why we were able to create a defence fund and plan it wisely and calmly. And that is why we can now learn from the mistakes of our neighbours and keep an eye on our economic growth.
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