ESTONIA'S NEW GOVERNMENT (PART IV): DOMESTIC AND

C O N F I D E N T I A L SECTION 01 OF 03 TALLINN 000273

SIPDIS

SIPDIS

E.O. 12958: DECL: 04/25/2017
TAGS: PGOV PREL EN
SUBJECT: ESTONIA'S NEW GOVERNMENT (PART IV): DOMESTIC AND
ECONOMIC POLICY PRIORITIES

REF: A) TALLINN 33 B) TALLINN 227

Classified By: CDA Jeff Goldstein for reasons 1.4 (b) & (d).


1. (SBU) Summary. As reported in reftels, On April 4,
2007, the Estonian Reform Party formed a center-right
coalition with the Isamaa-Res Publica Union (IRL) and the
Social Democrats (SDE). The new government has four key
domestic policy priorities: tax cuts, innovation,
bolstering the workforce, and enhancing energy security.
The government intends to:

-- Cut personal and corporate income tax from 22% to 18%
by 2011;
-- Find a technical fix to address EU concerns while
maintaining the policy of not taxing reinvested corporate
income;
-- Increase the budget for education and for R&D so as to
make the economy more competitive over the longer-term;
-- Address workforce constraints by increasing funding to
promote Estonia's incipient baby boom and lure back
Estonians who have emigrated; and
-- Improve energy security by investing in upgraded power
plants and "green" technology, participating in the project
to build a new generation nuclear plant in Lithuania and in
projects to link the Baltics with the EU energy grid. End
Summary.

Tax Cuts, Tax Policy and the Euro
--------------


2. (U) The centerpiece of the government's domestic agenda
is its ambitious tax cut plan. The coalition agreement
commits the government to reduce the flat income tax rate
from 22% to 18% by 2011. As its number one campaign
priority, the Reform Party pushed through the tax cuts in
coalition negotiations, justifying them as essential to
ensuring economic growth and keeping the economy
competitive. To allay public fears that tax cuts would
create a budget deficit, the government has pledged that
the cuts will be done in the context of a strict policy
that adheres to its goals for maintaining a surplus
(currently 3.8% of GDP) and reducing government debt
(currently 3.7% of GDP).


3. (C) Although they accepted Reform's tax cuts, SDE and
IRL interlocutors have expressed their parties' concerns
with the proposed plan. Unlike Reform, which predicts
economic growth falling no lower than 6%, IRL and SDE worry
that if the economy slows down faster than expected, the
government will not be able to afford the necessary
infrastructure or social and educational investment the
country needs. As SDE Secretary General Randel Lants put
it, "Reform's tax cuts may well eat up half our budget."
SDE leaders tried unsuccessfully to peg the tax cuts to
economic growth indicators during coalition negotiations.
If the economy fares worse than expected, SDE interlocutors
have told us they will reintroduce these measures.


4. (SBU) Inflation rates higher than the Maastricht target
forced Estonia last year to postpone the hoped-for adoption
of the Euro until 2010 or beyond. Critics have opined in
the press that the government's tax cuts will only
exacerbate inflation, making it more difficult to adopt the
Euro. The government's coalition agreement does make
transition to the Euro a priority, but it is short on
details. One high-ranking Reform official summed it up by
telling us off-the-record, "Economic growth is more
important than the Euro."


5. (SBU) The new GOE also appears to have settled on a
long-awaited solution to the dilemma of how it will
reconcile Estonia's signature policy of zero tax on
reinvested corporate profits with an EU mandate that would
also require zero tax on profits distributed to EU parent
companies. PM Ansip recently announced that Estonia will
allow the creation of "reserve accounts" into which
corporate profits can be paid. While Ansip committed to
preserving the zero tax on reinvested profits, working-
level contacts we have spoken to indicate there may be a
provision for taxing funds that are put into these reserve
accounts, without calling them either dividends or retained
earnings. Ansip has also committed publicly to maintaining
the kroon's current peg to the Euro at 15.64, rejecting
speculation about a possible devaluation of the currency.

Improving Education, Innovation and R & D:
--------------


6. (U) The flip side of Estonia's strong economic growth in
recent years has been a marked rise in wages, leading to an

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erosion of competitiveness. All three parties agree that
the government needs to improve Estonia's productivity, and
re-orient the economy to higher-value manufacturing and
services in order to ensure sustainable economic growth in
the face of global competition. The most commonly cited
strategies for doing so focus on turning out more
scientists and engineers, and spurring innovation as well
as research and development.


7. (SBU) The GOE sees education as central to improving
Estonia's competitiveness. Although it doesn't give a
precise figure, the agreement pledges to increase the
education budget annually by "at least the same pace as the
average growth of budgetary expenditure." Priority will be
given to improving school infrastructure, raising teacher
salaries, and modernizing the curriculum through
information technology across the board (e.g., primary,
secondary, and vocational schools). Government
interlocutors have told us that their objective is twofold:
to ensure high quality programs that are available for
everyone, and reduce the growing educational and digital
gap in the country. Despite all the positive press on "E-
stonia" in foreign papers, IRL Member of Parliament Ott
Lumi said that the educational and digital divide between
both urban and rural communities, as well as Estonian and
Russian-speaking communities, was only worsening. Lumi
noted that Estonia's mid-to-long term economic future
depended on the government's success in bridging this
divide.


8. (U) In addition to improving education, the government
will considerably increase spending on research and
development (R&D). The GOE is clear that spending the
Lisbon Agenda goal of 3% of GDP on R&D right now would be a
waste of money until more scientists and institutions are
in place to absorb this funding and put it to good use.
Currently, the Ministry of Economic Affairs and
Communication (MOE) estimates that roughly 400 enterprises
in Estonia (0.5% of all enterprises) are investing in R&D -
and many of these are quite small. The MOE's goal is to
spend 2% of the GDP on R&D by 2011 and, ultimately, 3% by

2015. The basic outline of their approach is to identify
Estonian firms and institutions with competency in three
key technologies: biotech, information technology, and
materials. A combination of state-run bodies (such as MOE
and Enterprise Estonia) and private venture-capital firms
(such as the newly formed Development Fund) will then
direct EU structural funds and equity investment capital to
these firms and institutions.

Workforce and Population
--------------


9. (U) A third domestic priority for the governing
coalition is the tight labor market, especially in services
and construction. (Ref A) Because of the already sizeable
Russian-speaking minority (approximately 37% of the
population),and a history of forced migration during
Soviet times, the coalition believes that large-scale
immigration from non-EU countries is politically
unacceptable as a solution to the shortage of workers.
Instead, the GOE plans to promote indigenous population
growth by increasing maternity/paternity leave and
benefits, providing higher incentive payments to parents
who have a third or fourth child, offering subsidized day
care and health care for children, and developing flex-time
and tele-working for working parents. The Ministry of
Population also recently announced the creation of a
position for coordinating the return of Estonians from
abroad, estimated to be approximately 32,000 (5% of the
workforce) since EU accession. While mass immigration is
not an option for the government, it does plan to offer
financial assistance in hiring highly qualified specialists
from third countries for short-term projects for Estonian
enterprises, mainly for product development (e.g., software
programmers, etc.).

Energy Security
--------------


10. (U) The final priority for the new government is in
the area of energy security. In this arena, the government
is moving ahead with a number of initiatives. These
include continuing ongoing upgrades to the country's
primary source of electricity, the Narva Oil Shale Power
Plants. Estonia is also setting targets for greater use of
biofuels and other renewables over the next five years and
building a liquefied natural gas (LNG) terminal at the port
of Sillamae. But their primary energy security initiative
is a partnership with Latvia, Lithuania, and now Poland to
construct a new nuclear power plant at Ignalina, Lithuania

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(Ref B).


11. (SBU) The GOE's goal for energy security, beyond
providing Estonia with alternate sources of electricity, is
to complete the circle begun with the Estlink power cable
to Finland by connecting the Baltic grid with Western
Europe's grid, the Union for the Coordination and
Transmission of Electricity (UCTE).


12. (SBU) Comment. Negotiations over the new GOE's
domestic policy priorities were settled relatively quickly
and amicably. What continues to hover over all these
ongoing discussions is the extent to which Reform's tax
cuts may limit the government's social agenda. If economic
growth slows down, IRL and SDE will likely hold Reform
responsible for any social cut backs. End Comment.
GOLDSTEIN