The Baltic Tiger

Commentary, David Seymour, Information Technology, Poverty, Role of Government, Taxation, Trade, Uncategorized

Estonia is a tiny nation with big public policy lessons for the rest of the world. Starting in the heady post communist days of the early nineties, a determined 32 year-old Prime minister and his government led the country through a series of economic reforms that would break most western policy wonks into a cold sweat. However Estonia’s success is forcing them to mop their brow and take a closer look.

After centuries of foreign occupation by Russia (three times), Germany, and Sweden, Estonia has most recently gained independence from the Soviet Union in 1991. That backdrop of strife mixed with staggering recent success makes this tiny nation, with a population and landmass similar to Nova Scotia, so inspiring.

Upon declaring independence Estonia was in a similar situation to other post Soviet states. Inflation was running at 1000%, unemployment was high, old Soviet era industries were crusty and inefficient, and there was little to be exported in return for foreign goods. Estonia wasn’t just poor; there was widespread poverty, while corruption meant a vast chasm between corrupt rich and dirt poor.

Estonia’s Government took the economic bull by the horns. The transformation from economic ruin to being listed as ‘high income’ by the World Bank has occurred at such dizzying pace t it is worth asking how they did it. In a recent interview with the Frontier Centre (interview), Former Prime Minister Mart Laar shed some light.

In 1994, Estonia became a pioneer of the flat tax. Unlike the common western system where higher levels of income face higher tax brackets, Estonia has only one tax rate on income. There is also an exemption level, below which income is tax free. Calculating income tax is a five minute process of ‘income minus exemption times the flat rate equals your taxes.’ There is no tax avoidance industry because there are no loopholes, it is fairer because it doesn’t matter how clever your tax lawyers are. Laar cites research finding that the exemption on low income and lack of tax avoidance makes the flat tax more progressive than bracket systems.

It also increases the incentives for earning. Once Estonians earn over the exemption threshold their ratio of tax to income stays constant. Proponents claim this simple effort and reward formula has contributed to Estonia’s bullocking economic growth. Indeed, thirteen years after the first European flat tax, 20 countries have adopted it in some form and nearby traditional economies like Britain are asking whether they can afford to keep ignoring its benefits. Indeed, Laar’s leadership in creating a simple, socially just, and economically empowering tax system makes Canadian politicians’ perennial horse-trading of cuts, exemptions and bracket shifts not just myopic but frankly embarrassing.

Before the flat tax, Estonia began an aggressive drive toward depoliticizing ownership of the economy. While the state originally owned everything, there is now only a port and some oil fields that are not in private ownership.

Another area where Estonia rushed in but many Western governments fear to tread is the total removal of barriers to foreign trade and investment. Rather than seeking to protect status quo industries, (“A lot of managers from the former Soviet factories came to me and said that I would destroy Estonian industry. I said it must be a very weak and uncompetitive industry which needs to be destroyed.”) Laar saw the potential benefits of interacting with wealthy European neighbours. Open economic doors have resulted in significant employment and plentiful cheap imported products. Large Scandinavian companies have relocated significant operations to Estonia’s investor friendly climate.

E-Stonia is also the world leader in e-government. Beside aggressive government programs aimed at giving internet access to all, the government is almost paperless. This rapid technology uptake is credited with making the government efficient and accessible; Estonia is even working towards online elections.
The results of these reforms have been spectacular. Estonia’s economy has grown at about three times the average western growth rate for the past decade. Inequality and unemployment are low (comparable to Canada), while a vibrant technology industry has, among other things, produced the world-beating internet products Skype and Kazaa.

It is unlikely that Canada’s economy could benefit from free trade, flat tax, or privatization to the same extent. Very simply, we are not emerging from decades of totalitarian rule, so we have less of the ‘catch-up effect’ that makes poorer economies grow faster. Also, Estonia is not perfect; there are claims that the country struggles to support its asset poor elderly who have never worked in the open economy, and of a growing urban-rural economic divide. Overall though, the Estonian experience of low flat taxes, free trade, and commitment to private rather than crown enterprise has been a boon for living standards and equality. It raises the question of whether countries like Canada can keep ignoring their experience.