Estonia’s tax system relies heavily on consumption taxes, particularly VAT, with income taxes forming a relatively small portion of revenue. This structure, while efficient, faces challenges in revenue generation given its narrow base. The country is experiencing elevated defense spending needs and long-term pressures from population aging and climate mitigation, creating fiscal imbalances.
The tax mix in Estonia resembles that of European emerging market economies more than advanced economies, with indirect taxes accounting for 42% of tax revenue and direct taxes for 29%. Compared to European advanced economies and the Nordics, Estonia collects significantly less tax revenue (22% of GDP in 2023), with VAT efficiency being the highest in the EU/OECD. However, the low tax effort and wider tax gap (14% of GDP) indicate untapped revenue potential.
Key issues and recommendations include:
- Personal Income Tax (PIT): The current system, with a high basic allowance and low statutory rate, leads to lower revenues and disincentives to work for middle-income earners. Options to strengthen PIT revenue include:
- Implementing a slightly more progressive structure, such as a two-rate system, which could improve work incentives and revenue mobilization.
- Exploring revenue-neutral options like increasing the tax rate or lowering the basic allowance.
- Corporate Income Tax (CIT): Estonia’s Distributed Profit Tax (DPT) system, while simple and efficient, has limitations in revenue generation. Options to strengthen CIT revenue include:
- Improving the current DPT design with a higher statutory rate.
- Transitioning to a standard CIT system with provisions like an Allowance for Corporate Equity (ACE) to maintain competitiveness while broadening the tax base.
- Exploring alternative rent taxes for efficiency gains.
- Value-Added Tax (VAT): Estonia’s VAT system is efficient, but further revenue can be generated by:
- Streamlining remaining VAT exemptions to broaden the tax base.
- Resisting the proliferation of reduced rates and exemptions as statutory rates increase.
- Strengthening tax compliance through measures like mandatory invoice declaration and expanding e-invoice coverage.
- Property Taxes: Estonia lacks a modern property tax system, relying solely on a land tax with widespread exemptions. Options to introduce a more comprehensive property tax include:
- Limiting exemptions on residential land.
- Developing a fiscal cadaster to ensure fair taxation based on property value and use.
- Implementing a flat-rate, value-based property tax with minimal exemptions and uniform treatment of business and residential property.
Overall, Estonia should consider a comprehensive review of its tax system to make it more robust, diversified, and capable of addressing current and future spending pressures while maintaining competitiveness.
