Tallinn, Estonia. An International Monetary Fund (IMF) mission, led by Vincenzo Guzzo and comprising David Bartolini, Bingjie Hu, and Hugo Rojas-Romagosa, met with the Estonian authorities during May 27-June 9 to conduct the 2026 Article IV Consultation. At the end of the visit, the mission issued the following statement:

A sizable fiscal expansion has lifted Estonia’s economic growth, but the war in the Middle East is now weighing on the near-term outlook through higher energy prices. Against the backdrop of increased inflation risks, policy efforts should focus on credibly stabilizing public debt through a balanced mix of spending restraint and revenue measures, thereby strengthening fiscal resilience and rebuilding buffers. Rising financial stability risks call for continued vigilance and readiness to address adverse macro-financial feedback loops should growth weaken. A sustainable improvement in Estonia’s growth prospects will require advancing structural transformation and policies to enhance labor allocation, deepen capital markets, including through progress toward the European Savings and Investment Union, and ensure a reliable energy supply.

Recent developments

1. Lifted by large fiscal stimulus, the recovery was gaining momentum before the outbreak of the war in the Middle East. Growth in the first quarter strengthened to 2.4 percent from a year earlier. The expansion was driven mainly by private consumption, boosted by the introduction of a universal personal income tax allowance, and, to a lesser extent, by public consumption. In contrast, investment remained subdued, despite the scaling up of defense equipment, and so did exports.

2. Inflation has rebounded. After declining steadily to a low of 3.2 percent in April, headline inflation rose to 4 percent in May, driven by sharply higher energy prices. Core inflation also increased slightly to 2.6 percent, while wage growth reached 6.2 percent in the first quarter.

Outlook and risks

3. The war in the Middle East is expected to weigh on the growth outlook, partly offsetting the impact of the large fiscal expansion. Higher energy prices are set to restrain consumption, investment, and external demand. At the same time, uncertainty may lead households to partly save the income gains from the deficit-financed tax cut, while the high import content of military equipment is set to dampen the multiplier effect of defense spending. As a result, growth is projected to remain moderate, at 2 percent in 2026 and 2.1 percent in 2027.

4. Higher energy prices are also expected to put upward pressure on inflation. The combined effect of the energy price shock and the large fiscal impulse is projected to raise headline inflation to 4.3 percent in 2026 before easing to 3.4 percent in 2027. Second-round effects on core and wage inflation are expected to remain contained, absent a more persistent energy price shock than assumed under the baseline.

5. The outlook is subject to considerable uncertainty, with risks to growth tilted to the downside and risks to inflation to the upside. As a small open economy, Estonia remains vulnerable to rising geopolitical tensions and a further escalation of conflicts. A more persistent energy price shock would have further adverse effects on growth and inflation. In a severe scenario, with oil prices doubling from pre-crisis levels and remaining elevated through 2027, inflation expectations would rise further, prompting a tightening of monetary policy. Growth would be significantly affected, reflecting a broad-based weakening of private demand, while inflation would also rise more sharply, sustained by second-round effects.

Fiscal Policy— Preserving Fiscal Space Under Rising Spending Pressures

6. The 2026 budget implies a markedly expansionary fiscal stance that is not warranted by current macroeconomic conditions. The introduction of a universal income tax allowance will significantly reduce revenue, while capital spending, including defense outlays, will increase rapidly. As a result, the fiscal stance is set to loosen substantially. Even absent the Middle East-related supply shock, such fiscal expansion would have been significantly larger than warranted by economic conditions. In the current context, however, it adds to demand pressures at a time when inflation is expected to rise due to the energy shock. A neutral fiscal stance—or, at most, a much more modest expansion—would help contain inflation and preserve fiscal space.

7. Staff recommend refraining from additional broad-based energy support and pursuing measures to contain the deficit. The suspension of the scheduled fuel excise increase to shield households and businesses from rising energy prices has further reduced revenue, albeit modestly. Any additional support should be considered only in the event of a severe, broad-based contraction in private demand and should be temporary and well targeted to the most vulnerable households and firms. Untargeted measures and generalized price subsidies, including VAT and excise cuts or price caps, should be avoided, as they distort price signals, weaken incentives to save energy, entail significant fiscal costs, and are difficult to unwind. Any spending under-execution or revenue overperformance should be saved to rebuild fiscal buffers, while spending overruns and revenue shortfalls should be offset through reductions in discretionary spending.

8. Fiscal imbalances are projected to widen beyond 2026, placing public debt on an unsustainable trajectory under current policies. The deficit is expected to remain elevated, leading to a persistent build-up of public debt from its still moderate level. Over time, this would raise gross financing needs and further erode fiscal space, increasing vulnerabilities to adverse shocks. While near-term sovereign stress risks remain contained, the longer-term debt outlook is a source of concern and warrants corrective action.

9. A credible consolidation strategy is needed to safeguard fiscal sustainability and preserve space for growth-enhancing spending. This requires a prudent adjustment path that keeps public debt below the EU reference value of 60 percent of GDP while maintaining a buffer of 20–25 percentage points to absorb future shocks and rising spending pressures, including from aging and energy security needs. In this context, staff recommend starting in 2027 a gradual but sustained annual structural adjustment of 0.5 percentage points toward a deficit of 1 percent of GDP, placing public debt on a stable path below 40 percent of GDP over the medium term. This consolidation strategy should be supported by a balanced mix of expenditure restraint and revenue measures.

10. The authorities should take steps to contain spending growth. In particular:

• Containing wage bill growth. The public sector wage bill has increased markedly in recent years, reflecting ad hoc agreements for specific workers’ categories. Further increases in staffing and compensation should be tightly linked to clearly identified service needs and measurable productivity gains.
• Strengthening private pension savings. Replacement rates in Estonia are low. Well-designed incentives for complementary savings would help address adequacy gaps while limiting future fiscal pressures. In this context, staff welcome the recently approved bill reducing the waiting period for rejoining the second pension pillar.
• Introducing means-testing for benefits. Benefits, especially those supporting families, are largely untargeted. Support should be focused on vulnerable groups. Rebalancing family policies away from cash transfers toward high-quality services should also be considered.
• Enhancing efficiency in healthcare delivery. The system faces rising costs and capacity pressures. Rationalizing service provision, strengthening prevention, and addressing staffing shortages, thereby reducing reliance on costly stop-gap measures, would help improve efficiency and contain spending growth.

11. Cost savings alone will not suffice, underscoring the need for a comprehensive assessment of the tax system to mobilize revenue while supporting growth. Estonia’s tax burden remains relatively low compared to EU peers and relies heavily on labor and consumption taxes, while revenue from income and property taxation is limited. In this context, staff recommend:

• Avoiding further erosion of the existing tax base. Reversing the recently introduced car tax or reducing VAT rates for food would be steps in the wrong direction, as they would lead to a considerable loss of revenue at a time when additional resources are needed. Targeted social benefits would provide a more effective way of helping those in need.
• Neutralizing the impact of recent personal income tax changes. The introduction of a universal tax allowance has removed distortions for middle-income earners but at a significant fiscal cost. Options to restore revenue include increasing the statutory rate or introducing an additional rate.
• Strengthening the role of corporate income tax. Staff analysis suggests that Estonia’s distributed-profit tax regime has improved corporate liquidity and reduced leverage but has not had a significant impact on investment over time. Transitioning toward a more conventional corporate income tax system with a broad base and a moderate rate could help mobilize revenue.
• Introducing a modern tax on immovable property. Estonia collects minimal tax on property. Priority should be given to further accelerating the phase-in of new land values and limiting exemptions. Over time, steps should be taken to set up a fiscal cadaster and broaden the tax base to include buildings, with well-designed deferral mechanisms to protect liquidity-constrained households. To strengthen incentives for property tax collection, municipalities should be granted greater tax autonomy, including by reducing reliance on shared revenues and central government transfers.

12. Budget processes have advanced significantly in recent years, and continued strengthening would support effective fiscal policy implementation. The authorities have made notable progress in developing performance- and activity-based budgeting, improving the availability of information. However, their use in guiding resource allocation could be further enhanced. Embedding regular spending reviews into the budget cycle and more systematically linking performance information to allocation decisions would help shift the framework toward a more results-oriented approach. Strengthening the analytical capacity and public role of fiscal oversight institutions would further enhance fiscal discipline and transparency.

Financial Policies—Safeguarding Financial Stability

13. Financial stability risks remain contained but have increased, warranting close vigilance. Banks’ exposures to real estate and construction are elevated, and cross-border linkages within the Baltic region add to these vulnerabilities. A significant weakening in economic activity could expose oversupply risks in commercial real estate, particularly in the Tallinn office segment. Funding risks also merit monitoring, given increasing reliance on online deposit platforms and, to a lesser extent, market-based funding, especially among domestic banks. The non-bank financial sector remains small and non-systemic, though some segments, notably consumer lending, exhibit riskier loan profiles.

14. Macro- and micro-prudential policy settings are broadly appropriate. Maintaining a tight macroprudential policy stance, including through the current countercyclical capital buffer rate, is important to safeguard financial stability amid sustained credit growth, elevated real estate exposures, and rising reliance on less stable funding sources. In the event of a severe downturn impairing credit provision, authorities should stand ready to release buffers to support lending, with any measures being targeted, temporary, and well-coordinated. Staff welcome supervisors’ scrutiny of online platform deposits and ongoing efforts to ensure that credit risk is properly reflected in risk weights across the banking system. The implications of AI and digitalization on financial stability warrant close attention as their use in the financial sector expands.

15. Estonia has made progress in strengthening its AML/CFT framework. Continued efforts are critical to mitigating financial integrity risks, safeguarding financial stability, and limiting potential reputational risk related to cross-border spillovers. Compliance with Financial Action Task Force standards has continued to improve, including in targeted financial sanctions related to terrorism and terrorist financing, as well as in areas related to new technologies. Further progress is needed to ensure that sanctions are effective, proportionate, and dissuasive; to reinforce oversight of designated non-financial businesses and professions; and to advance beneficial ownership transparency.

Structural Reforms—Building Resilience and Supporting Transformation

16.  Active labor market policies already play an important role in addressing labor shortages and skill mismatches and can be further strengthened. As demographic pressures intensify and recent gains in labor supply from migration recede, Estonia faces a structurally tight labor market. The authorities have made welcome progress in improving the use of information on vacancies and skills, and further efforts in this area would help better target policy interventions. Expanded training and adult learning, together with closer alignment of education with business needs, particularly in STEM fields, would facilitate reallocation toward more dynamic sectors and help prepare workers for the digital transition and the broader adoption of AI. Targeted incentives, including scholarships and tuition policies in priority fields, could further help address skill shortages. Strengthening migrant integration and addressing gender gaps in selected professions, including ICT, would further support labor supply.

17. Deeper capital markets through both domestic and EU-level measures could unlock further growth opportunities. Estonia’s innovation ecosystem relies heavily on intangible assets, which limits access to bank financing and underscores the importance of venture capital in supporting investment and firm growth. While Estonia has developed a stronger local venture capital market than many peers, scaling up remains challenging. Pension funds could play an important catalytic role in deepening local capital markets and attracting additional investors. Progress toward the European Savings and Investment Union would help integrate fragmented capital pools in Europe and support scaling up of Estonia’s innovative firms.

18. Expanding domestic electricity supply and strengthening market integration will be key to improving affordability, energy security, and emissions outcomes. Staff analysis suggests that enhancing domestic renewable generation, alongside stronger interconnections with neighboring markets, could reduce electricity prices by about one-third by 2040. This would also support growth, reduce import dependence, and mitigate the cost implications of EU climate policies, as Estonia transitions away from oil shale. Greater interconnectivity and investment in storage capacity would further enhance system flexibility, helping contain Estonia’s high electricity price volatility. Closer regional coordination on cross-border connectivity and cost-sharing of major infrastructure projects will be critical to advancing these efforts.

The mission would like to thank the Estonian authorities for their warm hospitality, close collaboration, and insightful discussions.