Estonian residents have high expectations of local governments. We are accustomed to cities and municipalities organising local life and providing high-quality, accessible public services. All of this requires money. At the same time, Estonia is one of the most tax-centralised countries in Europe. In financial terms, local government functions as an extension of central government. In a situation where the state budget is under pressure from defence, health and social expenditure and where public debt is growing rapidly, central government will no longer be able to support local governments financially to the same extent as before.
An administrative reform that remained unfinished
The 2017 administrative reform reduced the number of local governments from 213 to 79, increased the professionalism of staff and strengthened strategic governance. Yet the reform did not change the core of local government financing. Taxes remained centralised, while responsibilities were decentralised. The result is the system we have today: local politicians and community leaders are expected to be responsible for organising local life, but they have no real control over the formation of their revenue base. Instead of changing the tax system, the preferred approach has largely been to ask central government for additional funding within the existing legal framework.
Tax revenue at the centre, responsibility in local government
In OECD countries, local-level tax revenue accounts on average for 6–7% of GDP. In the Nordic countries, the figure is 10–15%. In Estonia it is up to 3%. In tax policy terms Estonia is highly centralised. While local governments in Finland, Sweden and Denmark set their own income tax rates, in Estonia even personal income tax - the main source of local government revenue, accounting for 57% of local budgets - is not a local tax. Fragmented responsibility weakens local democracy and makes it negotiable. The link between taxes and services also remains unclear to the local voter. Residents do not see a direct connection between what they pay and what they receive, nor can they assess whether local policy is expensive or affordable.
The fiscal impact of demographic change
Estonia’s population is declining, ageing and concentrating in major centres. At the same time, the cost of services is rising precisely in sparsely populated areas and in regions with older populations. This creates spatial and fiscal tensions between municipalities, because the burden of services and infrastructure often falls where jobs are located and services are actually used. The fairness of tax allocation is also distorted by the fact that nearly one fifth of people do not actually live where they are registered in the population register. As a result, the revenue base and the cost burden diverge. Local development needs and budgetary capacity no longer move at the same pace.
The population forecast prepared as part of the national spatial plan Estonia 2050 shows that, if current trends continue, population will keep concentrating in the suburban municipalities around Tallinn and Tartu, while growth in the capital itself would remain modest and Tartu would see no growth at all. According to the forecast, more than half of Estonia’s local governments will lose over 25% of their population over the next 25 years. At the same time, the population will grow in 14 municipalities, ten of them by more than 50%. These developments will affect the local supply of labour, the number of taxpayers and the critical mass of service users.
Economic development and taxing power
More than half of Estonia’s jobs are located in Tallinn and Tartu. We are in a situation where the functional region of Tallinn covers nearly one third of Estonia’s territory. Although local governments are tasked with developing the local business environment and strengthening regional competitiveness, their revenue base has no link to the companies operating on their territory. Corporate tax revenue goes to the state. This means that a municipality may plan industrial parks and attract investors, but the resulting tax revenue does not flow directly into its own budget.
Following market logic, economic activity concentrates in centres. There, companies find it easier to access suitable labour, specialise, cooperate with research institutions and build networks. Creating new jobs and retaining existing ones in rural areas requires greater effort than in cities. It would therefore be reasonable for rural areas to receive more revenue in return for their efforts to support jobs and economic activity. Money shapes behaviour. At present, local governments focus on retaining and attracting residents, because this increases personal income tax revenue. By contrast, the motivation and responsibility at the local level to support economic development and job creation are considerably weaker.
Regional equalisation is not a weakness, but a political choice
Tax policy cannot create a strong tax base in places where the economy is weak. Even with greater local tax autonomy, the need for regional equalisation would not disappear. This is why the state uses equalisation and support funds to smooth out spatial inequalities in national development. In a shrinking municipality, roads, school buildings and care needs do not disappear as the population declines. When shrinking regions become increasingly dependent on support, while growing regions expand their revenue base more rapidly, the equalisation system compensates at least partly for this inequality. However, it does not change the direction of a region’s development. It does, nevertheless, demonstrate the state’s willingness to maintain service capacity across the entire territory and to reduce the state’s retreat from peripheralising regions.
Robin Hood to the rescue
The 2024 amendment to the Income Tax Act, known as the “Robin Hood law”, redirects part of income tax revenue from wealthier local governments to cities and municipalities with lower revenues. Income tax on pensions was added to the local revenue base, directing more money to areas with older populations, at the cost of slowing the growth of income tax revenue in wealthier municipalities with growing populations.
Unfortunately, the current solution is not sufficient to genuinely balance the revenue base of municipalities with declining and ageing populations, nor does it resolve the contradiction of an Estonia developing at different speeds. The sharp decline in birth rates undermines the possibility of any similar future redistribution of revenue. If birth rates and population figures do not begin to improve, the service network will soon have to be scaled back rapidly.
The annual budget negotiation
Annual state budget negotiations between central government and local governments repeat the same pattern. Local governments complain about rising costs and argue that no better services can be provided with the money allocated. Although revenues have increased, the financial situation of local governments has generally worsened. Central government points to limited fiscal space. Mutual blame follows. This is not strategic governance.
We need greater budget transparency, a predictable budget that reflects actual cost growth and a fairer tax system. The budget would be more resilient if every municipality had a strong economic base. Since this is not the case, regional development requires state support that secures a basic level of services and indexes cost growth. Today the government determines the size of the equalisation and support funds and the discussion then turns to what can be done with that amount.
It is also appropriate to review the mandatory tasks currently assigned to local governments. We should assess whether certain local government tasks should instead be carried out by central government, which responsibilities should remain as they are today, and which could be performed through cooperation between municipalities - for example, by creating joint institutions or shared cooperation areas.
The latter would make it possible to apply asymmetry in the performance of local government tasks: some municipalities would have a broader area of responsibility, while others would have a narrower set of tasks. Today, with the exception of civil status procedures, which are assigned to the local government of the county centre, all local governments operate under the same model of responsibilities. The theoretical justification for asymmetry is that the tasks of each municipality should correspond as closely as possible to its geographic service area and economic capacity.
A choice, not a technical adjustment
For strong democracy, genuine self-government and greater resilience at the local level, the financing of local governments and the allocation of responsibilities require thorough analysis. The problem is not only the amount of money, but the logic of the system itself: the mismatch between responsibility, tasks and the revenue base and the deepening of regional inequality.
A political choice must be made. Do we want a centralised state where the local level is a strong administrator or a decentralised state where the local level is also a genuine decision-maker and strategic shaper of the future? This is not a technical question. It is a question of redistributing power, responsibility and money - and of deciding whether to maintain service capacity across the entire territory of the state or accept gradual retreat.
