Real GDP growth is expected to contract in 2023 by 2.6%, amid weakness in private consumption, sharply falling investment, downbeat demand from Estonia’s main trading partners, and the depletion of accumulated inventories. Growth is projected to turn positive in 2024 and more robustly so in 2025, as real incomes rise, and the trade outlook improves. Despite the planned VAT increase as of 1 January 2024, HICP inflation is projected to keep decelerating and to stand around 2% in 2025. The government deficit is expected to rise to 2.9% of GDP in 2023 and to slightly decrease to 2.4% in 2024, before surging to 3.6% in 2025 on the back of a cut in personal income taxation, while compensatory measures have not yet been specified. Public debt is expected to increase mildly to 23.2% of GDP in 2025.
| Indicators | 2023 | 2024 | 2025 |
|---|---|---|---|
| GDP growth (%, yoy) | -2,6 | 1,9 | 2,7 |
| Inflation (%, yoy) | 9,4 | 3,5 | 2,1 |
| Unemployment (%) | 7,0 | 6,9 | 6,8 |
| General government balance (% of GDP) | -2,9 | -2,4 | -3,6 |
| Gross public debt (% of GDP) | 19,2 | 20,5 | 23,2 |
| Current account balance (% of GDP) | 0,6 | 1,1 | 0,5 |
Real GDP keeps contracting
Estonia’s economy continued to contract in the second quarter of 2023, with private consumption, exports and investments declining, while government spending expanded only modestly. The preliminary flash real GDP estimate shows that economy also contracted in the third quarter, while confidence indicators suggest that the weakness also extended into the fourth quarter.
High inflation has taken a toll on consumption. Real wages are now rising on average, but they have not yet caught up with the past price increases, hampering consumers’ expectations about the economy and their own financial situation over the coming year. As nominal wages are projected to keep outpacing inflation in the coming quarters, consumption is expected to start increasing, though rather modestly as higher deposit rates offered by banks attract more savings. Consumption is set to recover more strongly as of 2024.
Businesses are particularly concerned with a fall in both domestic and external demand. Weak demand in Scandinavian, Baltic and, more recently, German markets led to a decline in goods exports. As a result, private investment has been very weak, a trend that is set to continue. On the positive side, public investment, which was lower than expected in the first half of the year due to long procurement processes, is set to increase and partially offset the fall in private investment. Specific sectors already suffer from more expensive financing, in particular startups, which by their nature do not have accumulated profits to rely on, and the construction sector, for which sharply higher mortgage rates have reduced the demand for residential construction. Higher borrowing costs are likely to weigh on investment in 2024.
Amid these weaknesses and due to the drag from the expected depletion of accumulated inventories, real GDP is set to contract by -2.6% in 2023, despite the countercyclical increase in public spending. A return to positive growth of 1.9% is projected in 2024, as real incomes outpace inflation and external demand gradually improves. Growth is forecast to accelerate further to 2.7% in 2025.
Labour market slowly starts turning
Up to now, the labour market in Estonia has been rather resilient despite the recession. Employment has been held up by labour hording and the use of flexible working regimes, such as shifting from full-time to part-time. However, the unemployment rate has increased lately, reaching 7.6% in August. Going forward, employment growth is projected to fall in construction, manufacturing, and retail sales, as signalled by surveys, though remain growing in services.
Inflation moderates
HICP inflation declined substantially, falling from double-digit numbers in the first five months of the year to below 4% y-o-y in September. Over the third quarter, slower price growth was recorded in all major HICP categories, while energy prices fell compared to a year ago. This reflects waning base effects, lower energy costs and lower food price pressures. Overall, HICP inflation is expected to average 9.4% in 2023. The moderation is set to continue in 2024, although a 2 pps. rise of the VAT rate as of 1 January 2024 will slow this process down. HICP inflation is projected to average 3.5% in 2024, and to further fall to 2.1% in 2025.
Tax rises on the horizon
The general government deficit is expected to increase, from 1% of GDP in 2022 to 2.9% of GDP in 2023, driven by a significant increase in expenditure on public wages (especially teachers and internal security) and pensions, as well as on new permanent spending programmes for defence, education and child benefits. At the same time, economic activity and tax base growth are substantially slowing down.
In 2024, the deficit is projected to decrease to 2.4% of GDP, as revenues are expected to increase by 0.6% of GDP on the back of an increase in the VAT rate and environmental taxation. In contrast, in 2025, the deficit is forecast to increase to 3.6% fuelled by the recently adopted changes to the income tax system as of 2025, permanently reducing revenue by 0.8% of GDP. Additionally, upward expenditure pressures on, for example, military and pension spending (indexed to last years’ wage growth and inflation) is also expected. In order to reduce the deficit, the government has announced, although not yet detailed, significant tax increases, including an undefined tax rise set to cover security-related expenditures, potential social taxation changes and a new car tax, as from 2025. At the same time, some expenditure cuts were also announced, but not detailed either. Hence, none of these measures – which, according to the medium-term budgetary strategy, could improve the fiscal balance by about 2% of GDP in 2025 – are accounted for in the current forecast.
Public debt is expected to increase from 18.5% of GDP in 2022 to 23.2% in 2025, while still remaining the lowest ratio in the EU.