The policy of annually-balanced budgets has a pro-cyclical bias and should evolve into a more flexible, rule-based counter-cyclical fiscal framework
During the past boom, the fiscal policy amplified an already highly pro-cyclical growth of credit and wages. The current downturn presents the opportunity to adopt a fiscal rule of balancing the budget over the cycle to allow automatic stabilizers to work. The deficit target could be anchored in a medium-term budgetary framework incorporating expenditure ceilings and a mechanism that claws back expenditure or debt overruns.
Financial stability should be strengthened, while distortions that contributed to the housing boom should be removed
Given the role of foreign-financed credit in the boom, and then the current recession, the Estonian Financial Supervision Authority should carefully monitor risks and intensify co-operation with the foreign supervisory bodies. The favourable tax treatment and credit guarantees of housing loans amplified the housing boom and should be phased out over the medium term to facilitate allocation of capital to its most productive use.
Labour needs to become more mobile across occupations, sectors, and regions for GDP to recover along a sustainable path of high growth
The importance of labour market flexibility is further underscored by the goal of adopting the euro in an environment of low, though rising, synchronisation with euro area business cycles. The recently-adopted Employment Act eases employment protection and enhances labour market flexibility. The parallel reform of the unemployment benefit system increases benefits and strengthens the financing responsibility of social partners. To improve incentives the unemployment benefit increase should be accompanied by additional measures supporting active job search. At the same time, job creation by firms could be enhanced through reductions in the social security tax. To prevent erosion of competitiveness, both minimum and public-sector wages should grow in line with productivity in the private sector. Over the medium term, regional labour mobility could be enhanced through increasing housing allowances and further improvement of public transportation infrastructure.
The business environment needs to become even more competitive to support innovation-driven productivity gains
OECD’s product market regulation (PMR) indicator confirms the overall very open and business friendly regulatory environment, although several specific weaknesses still need to be tackled. In particular, the impact of limiting the corporate tax liability to distributed profits should be carefully monitored and this tax regulation reconsidered if it is established that serious distortions arise. In addition, competition in the electricity sector could be increased, and cost effectiveness of programmes supporting business and innovation activities enhanced. Private sector activities in less developed areas of the country should be encouraged, in particular through facilitating access to credit for small and medium-sized enterprises.
