Estonia is a small country in Northern Europe on the Baltic Sea,
at the crossroads of East and West, South and North. Samuel
Huntington states that the Estonian border is a border of Western
civilization, a border where civilizations clash. This has made
Estonia interesting to historians but hard for people who live
Throughout history, Estonians have had to fight for their
freedom. In 1918, Estonia declared independence. It was
occupied by the Soviet Union in 1940 during the Second World War.
We fought the communist terror during the war but were
defeated. As a result of the occupation, Estonia lost nearly 20
percent of its population.
But we never gave up. When the 1980s offered us a new chance, we
took advantage of it. Estonia became one of the first countries to
pry open the cracks in the Soviet Empire. Finally, in 1991, after
50 years of occupation, Estonia became free again.
We had freedom but little else. Estonia was destroyed during the
period of communist rule. In 1939, Estonia's living standards and
way of life were more or less the same as neighboring Finland's.
Then Estonia lost its independence, but Finland, despite losing
territory and population, succeeded in keeping its independence.
Life under two different political systems created a huge disparity
in the development of Finland and Estonia. People learned and
worked hard on both sides of the Finnish Bay, but only the Finns
seemed to prosper. After starting from the same point, Finland's
gross domestic product (GDP) reached $14,370 per capita by 1987,
while optimistic calculations put Estonia's GDP at only about
$2,000 per capita.
At the same time, even opponents of communism often failed
to see the real economic problems stemming from the socialist way
of thinking. People overwhelmingly hoped that removing the
communists from power and liberalizing the economy would be
enough to enable their country to quickly reach the same living
standards as in Western Europe. Nobody actually understood how
backward and underdeveloped the communist economies
really were. As a result, the return to the free world was harder
and more painful than anybody could have predicted.
The Window of Opportunity
It was cold in Estonia in January 1992. The end of communism had
created real chaos in the country. Shops were completely empty, and
the Russian ruble no longer had any value. Industrial production
declined in 1992 by more than 30 percent--more than during the
Great Depression of the 1930s. Real wages fell by 45 percent, while
overall price inflation was running at more than 1,000 percent and
fuel prices had risen by more than 10,000 percent.
People stood in lines for hours to buy food. Bread and milk
products were rationed. Because there was no gas for heat, the
government planned to evacuate much of the capital of Tallinn to
the countryside. The only "institution" in Estonia that seemed to
work was the informal market.
Estonia was absolutely dependent on Russia, which accounted for
92 percent of Estonian international trade. Estonia had little
that it could sell on world markets. The Soviet command economy had
ruined Estonia's environment, and the infrastructure was in
catastrophic shape. For most foreign experts, Estonia was just
another "former Soviet republic" with not much hope for a better
Nor did many Estonians themselves believe in Estonia's future.
Seeing the chasm between reality in Estonia and what Estonians
understood as a more normal life, people realized that small steps
were not enough. Estonia needed to make a decisive, giant leap
across the abyss. At the same time, there was no time to lose.
Acting quickly was essential to reforming a country from its roots.
This was the main reason why in September 1992, in the first
democratic elections since World War II, the Estonian people
elected those offering the most radical break from the Soviet past
and the most decisive reform program.
Reform-minded governments are not given much time to take the
necessary steps. There are limits to the trust that people place in
their politicians and the level of pain that they are prepared
to endure. Exceeding these limits can set off a serious backlash
against the reformers and their new proposals. Lescek
Balcerowicz, one of the architects of Polish economic reform,
stressed the importance of "extraordinary politics," meaning that a
radical economic program launched as quickly as possible after
the breakthrough has a much greater chance of being accepted than
either a delayed radical program or a non-radical alternative
that introduces difficult measures gradually. In his own words,
"Bitter medicine is easier to take in one dose than in a
prolonged series of doses."
Balcerowicz's theory is based on the assumption that
liberalization from foreign domination produces in a country a
special state of mind and corresponding political
opportunities. Hence, the government has the possibility to make
decisions that would not be made under normal political and
In this sense, a crisis is not so much a crisis as an
opportunity. Even a short examination of Central and Eastern
European experiences shows no link between the intensity of social
discontent (e.g., demonstrations and strikes) and the type of
economic program pursued. In fact, delaying some necessary
decisions can cause serious backlashes that would not have occurred
if they were made at the right time. In reform, timing is
The right decisions made at the right time can provide countries
with advantages and guarantee greater satisfaction of the
electorate through more rapid development. The right decisions made
too late are usually still the right decisions, but the results are
often not as successful.
However, that window of opportunity does not last long. It
quickly gives way to the more mundane politics of contending
parties and interest groups, which is normal in established
democracies. Parties always search for an agenda, an
ideological profile to take more care of the practical
interests of their voters. Radical decisions become harder to push
through, and the speed of reforms naturally slows down.
Transition countries that do not take advantage of the period of
"extraordinary politics" to launch a radical economic program still
face the challenge of making the transition to a market economy,
but under more difficult economic conditions. The countries that
miss this opportunity risk macroeconomic instability,
excessive and chaotic state regulation, and massive
These countries are usually given a second opportunity after the
parties in power have totally failed, but if they miss the second
opportunity, it becomes extremely difficult to convince the people,
who have suffered twice the pain with no benefits, to go through it
all once more.
If essential reforms must be accomplished in a relatively short
time, preparation time is also brief. Laws that are passed must
therefore be as simple as possible, and the resources to implement
any particular decision are inevitably limited. This
limitation also argues for simplicity, a fact repeatedly
mentioned by Anders Åslund in his studies of transition
Estonia tried to learn from all such experiences. Two main
lessons emerged from our own reform process. One is to take care of
politics first and then to proceed with economic reform. The other
is summed up by the well-known advertising slogan: "Just do it." In
other words, it is essential to be decisive about adopting
reforms and stick with them despite the short-term pain that they
We had to deal with politics first because to initiate and
sustain radical reforms, we needed to form a legitimate consensus
for change. A consensus is possible only through democracy, using
regular, accountable institutional structures and free and fair
elections. To be successful from that point forward required a
clear break with the totalitarian past and with the structures and
people representing it.
The First Steps: Monetary Reform
and Macro Stabilization
The beginning of economic reforms in Estonia was similar to the
experience of other Central and Eastern European states (also known
as "transition economies"), but in some areas it was perhaps worse.
The Central European nations were able to start reforms earlier, in
1989-1990, while Estonian reforms began in 1991-1992. This loss of
time was crucial and allowed the Estonian economy to
The first real reform in Estonia was monetary reform in the
summer of 1992. Introducing our own currency was an important
challenge for Estonia. In the beginning, it seemed like a faraway
dream. Supporters of monetary reform suggested different paths
of reform, but all identified three objectives: eliminating
inflationary impacts from the east, guaranteeing an
equilibrium exchange rate based on supply and demand, and
conquering the cash crisis.
Estonia launched its monetary reform in June 1992 by becoming
the first country in the former Soviet Union to introduce its own
currency. Using a currency board system, the Estonian kroon was
made fully convertible from the first day by pegging it to the
German mark. Fixing the exchange rate to a strong currency like the
Deutsche mark created trust in the Estonian economy. However, to
reap the benefits of having a currency board, Estonia also had to
balance the budget. As a political slogan, balancing the
budget was quite popular, but in practice it was highly
Whereas in many other Central and Eastern European countries the
initial "shock therapy" was freeing prices to fluctuate, in Estonia
it was balancing the budget in 1992. The priority placed on
eliminating budget deficits was thus not only well grounded in
economic thought, but also, more practically, the only way out of a
desperate situation. The developments in several other Central and
Eastern European countries indicated that monetary reform
cannot succeed unless the budget is strictly controlled.
This became the task of the new government elected in September
1992. The government led by Pro Patria Union was built from groups
and parties that had been part of the resistance movement against
Soviet occupation and were therefore decisive in breaking with
the communist past. Members of the government were very young. As
the newly elected Prime Minister of Estonia, I was 32 year old, and
many ministers were even younger. Like other young people, we did
not know what was possible and what was not--so we did impossible
The buildup of a government action plan started with the
creation of a government coalition. Launching a radical reform
program would have been impossible without a firm and stable
majority in the Riigikogu, the parliament of Estonia. The size of
the majority was not important--the Pro Patria government had a
majority of one vote. What is important is that it works. For that
to happen, all members of the coalition must know their tasks and
the government's agenda.
To achieve this, our major focus was the coalition agreement,
which not only assigned cabinet seats among parties in the
coalition, but also clearly presented the government's action
plan. Every member of our coalition signed the agreement, which was
crucial to enacting the economic reforms in Estonia. Even when the
government's decisions were furiously attacked by the
opposition, the government had the necessary majority in the
Riigikogu to pass the necessary legislation.
Developing such a comprehensive program took some weeks. In
Estonia, this was done with the help of several think tanks from
abroad: The Heritage Foundation, the International Republican
Institute, the Adam Smith Institute, and Timbro in Sweden. Also
vital were the first Estonian think tanks, created years
earlier by the same parties that had just come to power. Most of
the reform agenda was presented and discussed at events
organized by these think tanks, making the public familiar with the
details. Without these think tanks, the fast and effective buildup
of a government action plan would probably not have been
Being prepared, we had the opportunity to act quickly and
decisively. Balancing the budget required radical cuts in all kinds
of subsidies and reducing the size of government. Each of these
cuts was unpopular. We pushed through these cuts thanks to the
coalition agreement, which established balancing the budget as the
most important goal.
We tried to include the opposition in the budget discussions,
but as in any other democratic country, the opposition was not
willing to cooperate and instead actively fought the budget cuts,
using both parliamentary obstruction and street
demonstrations. In this situation, the government needed to
ensure that all its majority voted and did not waste time on too
many discussions. (Once, we had to transport a member of parliament
who had just given birth from the hospital to parliament so that
she could vote on an important piece of legislation.)
Reforms must be pushed through, not piece by piece, but in the
biggest chunks possible. Political resistance to both small and big
reforms is the same. We passed huge amounts of necessary laws
within some months and balanced the budget. Afterward, we passed a
law that only a balanced budget could be presented to the Estonian
parliament. This requirement enabled the government to pass
subsequent balanced budgets more easily and has made a
balanced budget one of the trademarks of Estonia.
Estonia set achieving macroeconomic stability as its first
primary objective. Monetary reform, the strict restraint of a
pegged currency, and the balanced budget were all aimed at
achieving that goal. The stringent financial restraints made it
easier for the government to decide what to do. Without the ability
to print money or any other way to raise money, the government
could only balance the budget by cutting expenses. The
International Monetary Fund (IMF) offered a loan to balance
the budget, but the government decided to build the future of
Estonia on the momentum for radical reforms, not loans.
As part of this momentum, subsidies for state-owned companies
were identified as a poor policy, and they were cut. This was
important for the development of new private companies because
subsidies preserve old and often outdated production
structures and hamper structural change in the economy. Cutting
subsidies sent the Soviet industrial dinosaurs a simple and
clear message: Start working or die out. As was shown by subsequent
developments, the majority chose to start working.
It was important, therefore, that we were honest with our
partners and the public during the negotiations on the
coalition agreement. We said that the first years of reform would
be extremely difficult, so the members of parliament who had to
vote for such measures knew what would happen. This approach kept
the government coalition together, at least for a year and
Our government coalition understood that the only way out was to
continue along the path that we had charted. Otherwise, the people
would have endured the suffering which inevitably accompanies
stabilization of the economy but would have failed to see the
Estonia was confronted with an unavoidable decline in living
standards, industrial and agricultural output, and GDP. Any
movement toward prosperity therefore demanded the elimination
of old, inefficient, artificially supported economic activities and
the establishment of the "invisible hand" of the market
By 1993, we started to see the first real results of these
measures. The macroeconomic situation had stabilized. The inflation
rate had dropped significantly, from 1,000 percent in 1992 to
89.8 percent in 1993 and then to 29 percent in 1995. The
economy was reoriented from the East to the West, and exports
had started growing rapidly. All of these good signs gave us a
great chance to move to the second stage of reforms and put Estonia
on the path to real long-term growth.
The transition from the first stage of reform to the second
stage was one of the most decisive moments for the reform process.
In the first stage, many of the government's tasks were relatively
easy and largely determined by the realities of the existing
difficult situation. In the second stage, both the freedom to
choose and the consequences of those choices increased. In the
first stage, a small team could achieve macroeconomic stabilization
by implementing the reforms from the top down, but success in the
second stage required involving a much broader group of people in
the process, touching their hearts and changing their
The shock therapy of macroeconomic stabilization gave the
people a rude awakening. In the second stage, it was necessary
to give them new hope, new prospects, and new opportunities.
Without a major readjustment of attitudes, the post-communist
predicament would have become a trap, and the nation would never
have moved forward to become a "normal" country with a free
government and free markets under the rule of law.
Under Soviet-imposed socialism, people were not used to thinking
for themselves, taking the initiative, or assuming risks. Many
had to be shaken free of the illusion--common in post-communist
countries--that somehow somebody else would solve their problems
for them. It was necessary to energize people, to get them moving,
and to force them to make decisions and take responsibility for
themselves. The government declared that it could only help those
who were prepared to do something for themselves. This principle
proved unpopular, but it helped to change attitudes.
To accomplish these goals, Estonia had to find a way to give
people different opportunities to do business. To create that
opportunity, we felt that we had to open the economy to world
markets. We needed to foster competition and attract foreign
investment. Lots of people were afraid of such openness, so the
government had to show the way.
As a small, open economy, Estonia historically had relied on
trade. Openness provides many advantages for a smooth and rapid
transition to a market economy. It provides a rational set of
market-determined processes for resource allocation,
introduces more competition, allows countries to specialize
according to their comparative advantages, and lets the market
rather than the government pick the winners. A policy of
openness also establishes an environment of transparency, with
clear market-based signals for producers. This is also favorable to
the development of subcontracting activities that take advantage of
the transition country's skilled but low-cost labor.
Accordingly, Estonia reduced trade tariffs and non-tariff
barriers and abolished all export restrictions, making the
nation a free-trade zone. One reason for creating a free-trade
zone is that we found that tariff protections primarily favored
sectors that are politically organized rather than those that are
in the most need.
This open trade policy proved to be highly successful, boosting
competition, reconstruction, and growth. Openness brought to
Estonia many new companies, which opened new,
export-orientated factories. Of course, this policy provoked
furious opposition, demonstrations, and petitions "to protect
strategic parts of economy" or "defend local producers."
We did not pay much attention to such protests and pushed
reforms through as fast as we could. Once the first results of
openness were seen, reversing the reforms became much more
difficult. Openness will always be politically unpopular, but
nobody wants to change a system that works.
For a transition economy like Estonia's, attracting foreign
investment was a superior alternative to borrowing from
international institutions, such as the World Bank and the IMF.
First, by accepting development aid, we would have run the risk of
maintaining the relative backwardness of our country.
Development aid may consist of obsolete technology and
obsolete advice, which no longer assists modern countries. By using
this assistance, countries in transition lose the opportunity
to use their backwardness as a springboard for development.
To put it bluntly, give us no aid, but more trade. The
opposition heavily criticized this decision, but we paid little
attention to this because the decision was supported by the
parliamentary majority. When presenting such a decision to the
people, stressing their national pride, they understand it quite
Although interest in foreign investment is relatively
similar in all transition countries, the results achieved differ
enormously. Some countries try to encourage foreign investors by
offering all sorts of enticements, such as tax exemptions,
privileges, and special rights. The alternative is to build a
business environment that favors both local domestic
investment and foreign investment without making any distinction
Estonia chose the latter path. At the beginning, there was a lot
of discussion about this approach, but because we had written it
into the coalition agreement, it was done quickly. When the
positive results of this policy were seen within a few years,
nobody wanted to change it.
Passage of the law on the sale of land ensured that all foreign
investors could feel a greater sense of security, and it also
signaled that their property rights would be protected. At the same
time, all special privileges for a few foreign investors were
abolished, encouraging all kinds of investment. Soon after,
during 1993-1994, Estonia went from an almost unknown spot in the
world for foreign investors to a mecca for them. The
government's systematic work to build a good reputation for
Estonia in the world also helped to boost foreign investment.
As a result, Estonia received more foreign investment per
capita in the second half of the 1990s than any other country in
Central and Eastern Europe. This large inflow of investment created
new working places, reconstructed old factories, brought new
knowledge and technology, and made Estonia more modern and
Yet to be truly successful in transition, a country must open
its markets not only to the world, but also to its own people.
Democracy and the buildup of civil society must be supported. An
important step in this regard was the introduction of a social
dialogue or partnership. In practice, this meant initiating
trilateral negotiations among the state, employers, and
employees. During 1992 and 1993, the government supported the
transformation of the Soviet-type trade unions into free trade
unions. This created a dialogue between the government and the
trade unions that averted larger protests and demonstrations,
particularly during the first painful period of reform.
During trilateral negotiations, the government explained the
Estonian situation to the other two sides. It was important to
concentrate the negotiations on the most difficult problems,
creating clear priorities. For example, when we agreed that our
biggest common goal was fighting unemployment, explaining what
steps were needed became significantly easier.
Trade unions understood that even though a lot of working places
would be lost during privatization, privatization was the only
way to escape from the current situation. If the enterprises were
not privatized and reconstructed, all of the workers in the
enterprises would lose their jobs. As a trade-off, the trade unions
were given the possibility of presenting their proposals to
the Privatization Agency on how many jobs must be guaranteed
in privatized enterprises as a condition for a privatization
agreement. Most important was to make clear to the trade
unions that they really had access to the government and to
establish a regular dialogue between the government and the
All of these steps gave a firm boost to the development of
a civil society in Estonia by helping to bring on fundamental
changes in mentality and attitudes. The people became used to
expressing individual opinions and actively influencing decisions.
They understood that their future depended on their own activity.
It is important to support the development of free media, even when
they often become critical of the reform government. Freedom of the
press is an essential part of modern society, without which
society cannot function. Establishing democracy at all levels
of society is crucial for successful transition. Only then can one
be sure that the results of transition will not be turned back
at any moment.
The Rule of Law
Radical economic reforms cannot be implemented without laws
regulating the economic space. Although the rule of law has been
and still is one of the pillars of modern Western civilization, its
importance was not readily understood in several transition
economies. Some believed that decisive reforms could be implemented
without supporting laws by using only government decrees or simply
letting the old structures collapse without creating new
legislation and institutions.
In some transition countries, politicians regrettably
believed that a free-market economy could magically create
wealth without clear laws or government to enforce those laws.
Often, they paid insufficient attention to renewing and
strengthening--not enlarging--the government.
However, good laws by themselves are not enough. All developing
economies need to build effective institutions that move their new
laws from paper to practice. Formal legal systems place judges,
prosecutors, arbitrators, court functionaries, and the private
legal profession in the role of primary interpreters and enforcers
of laws. Developing and securing all of these systems is
vitally important for the reforms' success, as is creating an
effective civil service.
The rule of law is especially important in fighting corruption,
one of the worst diseases of transition economies. Corruption
thrives when public officials and private agents have much to gain
and little to lose from taking a bribe, which is precisely the
situation that exists in most transition countries.
Uncertain or non-transparent rules, heavy regulation, and
pervasive controls give officials exceptional power, many
opportunities to seek bribes, and a wide scope for appropriating
The Estonian experience illustrates that the most effective
method of dealing with corruption and organized crime is decisive
implementation of market economy reforms and the development
of a civil society and the rule of law.
Any reform that increases the competitiveness of the economy
will reduce incentives for corrupt behavior. Reducing controls on
foreign trade, removing entry barriers to private industry, and
privatizing state companies in a way that ensures competition
supports the fight. If the rules are transparent and clear, and if
the state has no authority to license businesses or restrict
exports and imports, there will be no opportunities to pay bribes
in those areas. Eliminating subsidies, "soft" loans, and all other
such privileges removes another inducement for bribes.
Using such methods and policies, Estonia fought and successfully
reduced corruption and organized crime. Opening the national
economy to competition and introducing real reforms is the best way
to avoid crony capitalism. It is important to give enough attention
and resources to judicial reform, reform legislation, police
forces, and building an effective and transparent administration,
even though these areas may not look so necessary in the first
years of reform. Estonia put these areas on the priority list of
reforms and became the least corrupt country among all
transition countries, achieving a better score in the
international corruption index than some long-standing member
states of the European Union.
Finally, special attention must be given to bank reform. Banks
are a most important part of the economy. If organized crime takes
control of them, it can quickly take over the entire country. Money
laundering, dirty money, and all other nefarious operations must be
separated from the banking system as soon as possible.
Government must be extremely vigilant and tough on this issue
because dirty money is always followed by dirty people.
Estonia eliminated all state banks and made very clear demands
of private banks. Banks were to compete, and we did not
hesitate to let them go bankrupt when necessary. As a result
of this clear attitude, Estonia has the most effective banks in the
Baltics and is less corrupt than other new EU member
At the heart of economic transition is a shift to private
ownership. Without private ownership, the transition to markets is
destined to fail. There are different ways to achieve a secure,
free economy with strong property rights: restitution of property
to former owners, privatization of existing state assets, and the
re-emergence of private businesses. For reformers, the question is
not how much to privatize, but how and when to privatize.
Privatization is never actually popular. It does not win votes.
This means that privatization must be implemented as quickly as
possible. There is no time for negotiations with the opposition,
and they will fight it anyway.
Property reform and privatization are especially important
because clearly defined property rights are essential to all truly
reforming economies. These two reforms are a necessary precondition
for a functioning market and the only way to change the
behavior of people and businesses and encourage them to begin
making the most important structural changes. Getting the economy
on this road to change, not maximization of revenues, is actually
the most important goal of privatization.
At the same time, it is important to clearly guarantee
property rights and to create the necessary legal conditions and
institutions to make this happen. Property laws must leave no
room for interpretation. Accomplishing this goal, however, is
not easy because property relations are always one of the most
complicated parts of legislation. The situation is even more
difficult because such laws must be passed quickly to prevent old
property relations from contradicting new ones.
In Estonia, we passed the first laws on property reform in early
1992, concentrating first on returning property that had been
confiscated or nationalized by the communist rulers to the
original, legal owners. In cases in which directly returning
property was not possible, people received compensation,
not in money but in the form of privatization vouchers. With these
vouchers, they could buy minority shares of privatized companies or
land. When it was clear which property would to be given back to
the legal owners, all other property was privatized. Land and
housing were privatized using vouchers that people had received
previously, quickly making as many people as possible owners of
This was a complicated process. Left-wing parties protested
furiously against such measures and organized rallies against them,
but we stayed firm and accelerated the process. Once people have
become property owners, the process can be reversed only by brute
force. As in all other reforms, speed is important in property
reforms. At the same time, it is necessary to pass the laws that
guarantee real protection of property rights, not only in theory
but in reality.
Larger objects were privatized by the Estonian Privatisation
Agency, Estonia's Treuhand, in open bids. In most cases, a majority
share of each company was sold to one core owner, and minority
shares were sold to individuals for vouchers. This guaranteed
legitimate owners for companies while ensuring that everybody could
participate in the privatization. The goal of privatization was to
guarantee necessary investments and a minimum number of
workers in privatized factories for a certain time, not just to
generate revenue for the government. As a result of these
policies, the privatization process was smooth and fast, making
Estonia a country of property owners.
The Flat Tax
To achieve a lasting breakthrough in Estonia's development, it
was essential to make the most of the people's energy.
Accomplishing this goal required both creating a favorable economic
environment for private enterprise and inspiring people to
assume responsibility for their own future.
While the second goal was attained largely through shock
therapy, achieving the first objective was much more complicated.
It was partly accomplished through adopting legislation based
on liberal or limited regulation of the economy, thus depriving the
bureaucracy of opportunities to intervene or easily undermine
the foundation of new companies.
However, limiting regulation was not enough. When people who had
started their own companies realized that the tax system punished
success, their enthusiasm to persevere and determine their own
future declined considerably. In this situation, they were more
ready to move from the traditional tax system to a new and radical
Radical tax reforms are popular only while they are part of
theoretical discussion. When politicians try to implement them, the
reforms immediately become highly unpopular. Winning elections on a
platform of tax reform is difficult, but once a government is
in power and must give the economy a boost, cutting tax rates is a
This step demands great political courage. Governments that
cut tax rates or move to the flat tax are inevitably accused of
supporting the rich, even though nearly all such tax reforms result
in the rich paying a larger share of tax revenue than before. This
fear of being labeled a supporter of the rich is a main reason why
governments hesitate to introduce tax reforms, even when they know
that such tax reforms are necessary. They are afraid of being badly
defeated in next election.
Making the right decision and enacting the right policy are more
important. I was certain that we must not punish people who are
good at what they do. On the contrary, we decided to give them the
opportunity to work more and to take control of their future.
We decided that the entire tax system should favor savings and
investments and encourage people to create new wealth. The tax
system in Estonia had to be simple, inexpensive to apply, and
transparent and understandable to the taxpayers. The tax base
should be as broad as possible with a minimum number of exemptions,
minimizing incentives for tax avoidance such as the underground
economy. The tax rates had to be low, encouraging the activity of
people and creating more growth.
The best solution to all these goals was a flat-rate personal
income tax, and Estonia introduced such a system on January 1,
The tax system became simpler and easier to understand for both
taxpayers and tax collectors. Taxpayers could easily fill out their
tax forms and avoid overly complex calculations and bureaucracy.
Tax collectors could avoid a lot of unnecessary work and
concentrate on those who were not paying their taxes at all.
As a result of these simplifications, the tax administration
started to work more effectively, and tax compliance increased. The
grey sector was badly hit, and state tax revenues started to
increase rapidly. (See Chart 1.)
The flat tax reform also supported a rapid increase in economic
activity. The Estonian people saw that if they worked more, they
could earn more without the government punishing their success
through higher tax rates.
Attitudes changed surprisingly fast. Thousands and thousands of
new small and medium-size enterprises, restaurants, hotels,
and shops were established. In 1992, Estonia had about 2,000
enterprises. By the end of 1994, the figure had ballooned to
70,000. Estonia had changed from the country of the working class
to a country of entrepreneurs. The incentives to take charge of
their own future helped Estonians to avoid massive
Even after the Pro Patria government was voted out the year
after tax reform, the flat taxed stayed. It turned out to be so
effective that nobody seriously wanted to change it. Since 1994,
Estonia has seen all possible government coalitions, often of
parties that won elections by promising to abolish the flat-rate
tax. Yet the flat-rate income tax persists.
The Estonian experience with the flat-rate tax was so successful
that other countries--first Lithuania and Latvia and then Russia in
2001--have copied it. Ukraine and Georgia have also introduced a
flat tax, as did Slovakia in 2004 and Romania in 2005.
The flat-rate income tax has increased economic activity
everywhere, created new workplaces, and suppressed the gray
economy. Comparing the economic growth rates in Central and Eastern
European countries with flat-rate personal income taxes to the
growth rates of economies in the same region with progressive
income taxation, we can see that countries with flat-rate taxes
grew faster on average.
Comparing Central and Eastern European countries with flat rates
(Estonia, Latvia, and Lithuania) to the most similar countries
(Slovenia, Poland, Hungary, Slovakia, and the Czech Republic),
we can see that the flat-tax countries grew significantly faster
both in the first years after introduction of the flat tax and
during the past three years. (See Chart 2.)
The countries with flat-rate tax systems have reduced the
relative income gap (in GDP per capita) with "Old Europe" much
faster than other countries. Eurostat figures show that
Estonian GDP per capita was 34.8 percent of the European average in
1996. Hungary was 48.5 percent, and Poland was 42.1 percent. In
2007, per capita GDP is roughly 65 percent in Estonia, 64 percent
in Hungary, and 52 percent in Poland. The average catch-up of the
three flat-tax countries is 25 percentage points, compared to
Central and Eastern European countries with progressive taxes that
experienced only a 14 percentage point catch-up.
The other clear difference between the flat-rate and
progressive-rate countries is that the flat-rate countries'
revenues and budgets are in better shape. Opponents often argue
that the flat-rate personal income tax is socially unjust because
it creates bigger inequalities in society than progressive
taxation creates. This assertion is untrue, as the Gini
coefficient of income distribution has often decreased
in flat-rate countries and is often lower than in progressive-rate
countries. (See Table 1.)
In Estonia, the main increase in the Gini coefficient took
place in 1989-1993, reaching its peak in 1995 with 0.398. It
decreased in subsequent years.
The flat-rate tax increased budget revenues, reduced incentives
for the gray sector of the economy, and supported growth and
economic activity. With such positive results, the Estonian example
is now followed by more and more countries, pushing all Europe
nearer to a real tax revolution.
The Estonian Miracle
Radical reforms in the 15 years since 1992 have changed Estonia
beyond recognition from its communist days.
It is sometimes hard for us to remember how this country looked
under the old system. Estonia became the first former communist
country to rise to the status of a "free" economy in the annual
Index of Economic Freedom, published by The Heritage
Foundation and The Wall Street Journal. Even more
remarkable, it is not just a "free economy," but one of the freest
in the world, ranking 12th in the 2007 Index of Economic
As a result of this amazing transformation, Estonia has
experienced the fastest economic growth in Europe during the past
few years. Since the start of Estonia's reforms, economic growth
has averaged 6 percent per year. Growth was nearly 11 percent in
2005 and nearly 12 percent in the first half of 2006. As a result
of this formidable growth, Estonia is catching up to the average
European living standard faster than anybody expected.
Poverty and inequality are decreasing in Estonia. According
to the United Nations Human Development Index, Estonia has moved
from the group of not-so-developed countries to the group of
developed countries. Estonia has low unemployment and low
inflation, and living standards are improving rapidly. The budget
is not only balanced, but also running a strong surplus.
Estonia has passed several social reforms, such as health care and
pension reform, and has become a full member of both NATO and the
By nearly any standard, Estonia is the most competitive economy
among new EU member states. Only 10 years ago, Estonia clearly
lagged behind most Central and Eastern European countries, but
it has since passed them and is fast approaching the living
standards of Old Europe.
All of these changes have allowed Estonia to prepare for
the new challenges of the 21st century. The nation made a real jump
in modern technology and is a frontrunner in e-government. During
cabinet meetings, members of the government use only computers--no
paper at all. Estonia is now ahead of many EU countries in Internet
use. Estonians transact a large part of their bank transfers
through the Internet. Tax declarations can be sent to the Tax
Department electronically--more then 70 of Estonians did this
in 2006. Best of all, completing the tax form takes about five
E-government can be a very effective tool in creating a
lean and open government. The government's use of the Internet
has in turn created favorable opportunities for new high-tech
enterprises. Estonia has become the birthplace of many such
enterprises. The most famous Estonian invention is the Skype
electronic communication system, which was voted third most
influential new trademark in the world in 2006. Of course,
there is still a lot work to do. Estonia must face new challenges,
but that really depends on Estonians themselves: The most difficult
years are behind us.
Looking back on Estonia's transition from misery to prosperity,
I can say from personal experience that the prime minister's task
is not to be popular, but to build a working coalition, have a
clear program of what to do, and then have the courage to make
In a democracy, no prime minister stays in power forever, but a
prime minister probably has a better chance of returning to power
or staying in power when people can see that he really achieved
something. I am a living example of this. I am the only prime
minister in the transition countries who was voted back into power
after being ousted, and I am the longest-serving prime
minister in Estonian history.
Of course, implementing reforms can make a government unpopular.
Thus, governments that implement such policies run the risk of
being ousted from power sooner rather than later, but this is not
important. Changing the country for the positive beyond recognition
is far more important. Looking back, one can say: This was a dirty
job, but someone had to do it. Once set in motion, the train cannot
be easily stopped, and this is actually the only thing that
The Honorable Mart Laar served as
Prime Minister of Estonia from 1992 to 1994 and from 1999 to
This is the third in a series of first-hand accounts of how
countries achieved notable economic success by following the
principles of economic freedom. Previous papers are: "How
Ireland Became the Celtic Tiger" (Backgrounder No. 1945)
and "How Chile Successfully Transformed Its Economy"
(Backgrounder No. 1958).
Samuel P. Huntington, The Clash of Civilizations and the
Remaking of the World Order
(New York: Touchstone, 1996), p.
Leszek Balcerowicz, "Understanding Postcommunist Transitions,"
Journal of Democracy, Vol. 5, No. 4 (October 1994).
Anders Åslund, "Possible Future Directions for Economies in
Transition," in Joan M. Nelson, Charles Tilly, and Lee Walker,
eds., Transforming Post-Communist Political Economies
(Washington D.C.: National Academy Press, 1998), pp. 455-470, at
(July 31, 2007).
Gini coefficient is a measure of income distribution on a scale
from 0 to 1, with 0 corresponding to perfect income equality and 1
corresponding to perfect income inequality.
Kane, Kim R. Holmes, and Mary Anastasia O'Grady, 2007 Index of
Economic Freedom (Washington, D.C.: The Heritage Foundation and
Dow Jones & Company, Inc., 2007), at www.heritage.org/index.