The 1988–90 Tax Reforms

At the beginning of 1988, the authorities introduced a VAT and a personal income tax (PIT). A year later they unveiled a new enterprise profit tax (EPT) and abolished several existing direct and indirect taxes. The reform was aimed at correcting the distortions stemming from a discretionary and selective system of taxation. The excessive burden of direct taxes on enterprises was to be reduced—offset in part by the grossing up of wages paid in the socialized sector by the equivalent of the personal income tax liability of wage earners—and an increasing share of budget revenue was to be obtained from taxes on personal incomes and final consumption.

The introduction of the VAT and PIT in 1988 was accompanied by the elimination of most consumer turnover taxes,³ the net worth tax, the investment tax, the municipal contribution from profits, and the wage bill tax on enterprises.

The VAT applied to most goods and services, with special provisions for small firms, household services, and housing construction. The tax was fully rebated on exports; no rebate was granted in 1988 on socialized sector investment expenditures, but the rebate was phased in gradually beginning in 1989, reaching 60 percent in 1990. In 1990, investment in disadvantaged areas, or for environmental protection or by joint ventures, had a zero VAT rate. The VAT rates ranged from the normal 25 percent, to a reduced rate of 15 percent mostly for services, and to full exemption for more than 40 percent of consumer expenditures, mainly food, household fuel, and transportation and communication services.

The PIT applied to the global income of individuals. It taxed for the first time wages earned in the socialized sector and superseded the schedular income taxes paid on various private economic activities. Socialized sector wages were grossed up to preserve the net income of employees. Secondary incomes from private activities were aggregated and taxed at the marginal rate, which increased the tax burden on such activities.

Originally, the PIT rates ranged from 20 percent to 60 percent in eleven brackets, with an average tax rate of 14.5 percent. Of five million potential taxpayers, about 20 percent were expected to fall below the threshold of a general tax-free allowance of Ft 48,000 a year—equivalent to about two thirds average earnings in the socialized sector. The taxable unit was the individual rather than the family, but a separate standard deduction was granted for the cost of raising children. Special provisions applied to incomes from small-scale farming and from intellectual activities, and most social benefits were exempt, with a tax-free allowance available for pensions. Interest and dividend incomes were subject to a separate flat rate tax of 20 percent, and generous provisions were granted for the deductibility of savings for housing purposes and interest on housing loans. For incomes from employment and interest, the tax was withheld at source. In 1989, the tax-free allowance was raised to Ft 55,000 a year and the marginal tax rates were lowered to between 17 percent and 56 percent, the number of brackets to eight, and the average tax rate to about 14.6 percent. In 1990, the number of brackets was reduced to five and the top marginal rate to 50 percent. Higher-than-expected wage increases, however, placed individuals in higher marginal tax brackets, thereby raising the average tax rate to an estimated 16.4 percent.

The EPT introduced in 1989 was aimed at providing a uniform system of taxation for all enterprises. Accordingly, the “countervalue tax” on subcontracting to economic partnerships of employees was abolished and the entrepreneurial tax integrated into the EPT. Individual undertakings, including small-scale farming, remained subject only to the PIT but could have their profits taxed under the EPT. In a further effort to streamline the tax system, the authorities removed several production taxes in metallurgy, the chemical industry, transportation, and public services. An EPT rate of 50 percent was approved with a 4 percent surcharge; a reduced 40 percent rate applied to the first Ft 3 million tranche of the annual profit of any enterprise, in order to favor small businesses. Under the EPT, several tax preferences were maintained, with a view to stimulating such economic activities as farming, food processing, and grocery trade, as well as research and development, cultural, health, and social services. In 1990, the EPT rate was reduced to 40 percent (35 percent for the first Ft 3 million of profits); an 18 percent dividend was introduced, payable by state enterprises on their after-tax profits—a measure intended to equalize the treatment of all enterprises with respect to taxation and the return on capital to owners.

Tax incentives were also given to joint ventures with foreign partners. Tax allowances of 20 percent on the payable EPT were granted to joint ventures with a foreign share of at least 20 percent, or Ft 5 million. The allowance could rise to 100 percent for activities in priority sectors during the first five years, to be lowered to 60 percent in the sixth year. Profit taxes on reinvested earnings of the foreign partner were fully refunded. Effective January 1, 1989, a new Foreign Investment Law included guarantees for the protection of the investment and the transfer of profits and all other stipulations governing foreign investment in Hungary.

The tax reforms of 1988-90 sought to establish a more transparent, neutral, and stable financial environment for economic decision making by both households and enterprises. The rules of taxation were to be subject to parliamentary approval and major steps were taken to streamline the structure of the tax system. However, distortions remained. Under the EPT, not only were many old allowances permitted to continue, but new allowances were introduced in 1989 and 1990. As a result, the marginal effective tax rate on investments varied widely. The standard VAT rate of 25 percent was high because a zero VAT rate applied to many consumer necessities, which created inefficiencies in consumption choice. The PIT applied mostly to cash payments, excluding benefits provided to employees in kind.

In July 1990, the new Government, as part of its corrective fiscal package, increased the dividend payable by state enterprises to 25 percent. In 1991, a major structural change associated with the conversion of CMEA trade to world prices was the elimination of revenues from the differential producer turnover tax on CMEA trade. This revenue loss was partly offset by higher duties on petroleum and luxury products.

The Government recognizes the need for further reform of the tax system. Its objective is to broaden the tax base and lower the burden of direct taxes. For the personal income tax, elimination of current widespread exemptions will permit the introduction of a more gradual progressive scale of taxation, which will provide enhanced incentives. The Government is considering narrowing the range of VAT rates. It is currently preparing proposals for reform of the tax system. A significant reduction in government spending will permit a lowering of tax revenues relative to GDP, while achieving fiscal balance by 1993.

Budgetary and Social Security Reform

At the time of the adoption of the PIT and VAT in the fall of 1987, Parliament instructed the Government to design a blueprint for comprehensive budgetary reform. The principal aim was to scale down substantially and rationalize government intervention in the economy. The authorities made some progress in this direction; producer and consumer subsidies declined to 13 percent of GDP in 1989, from 21 percent in 1986. In 1989, the National Savings Bank stopped granting exceptionally low-interest housing loans and losses of the newly established Housing Fund’s portfolio of low-yielding assets were to be absorbed by the budget (see Section VIII). Housing loans continued to be extended, however, at below-market interest rates. In 1990, the Government took a first step toward reducing the burden of housing finance on the budget by imposing a tax on pre-1989 subsidized housing loans granted at preferential interest rates ranging from zero to 3.5 percent. Rents on local council apartments were also raised by 35 percent. The tax on old housing loans, however, was ruled unconstitutional by the Constitutional Court in March 1990.

The budget reform aimed at replacing broad objectives guiding the provision of health, cultural, social, and housing services to the population—which in many cases remained unfulfilled—by more narrowly but clearly defined services in these areas. Eligibility for these services was, where appropriate, to be more closely related to need. An important element of this program was the reform of social security. A first step in this area was taken at the beginning of 1989, when the authorities separated the social security accounts from the state budget and raised the state sector’s employer’s contribution to 43 percent, equivalent to the private sector rate. In January 1990, the Social Security Fund assumed responsibility for health care, while in April 1990 responsibility for family allowance transfers was moved from the fund to the state budget. The intention was to adopt guaranteed basic social security entitlements supplemented by insurance-based benefits. Finally, the budget reform also sought to address the issues of revenue sharing with local authorities, funding and control of budgetary institutions, and improvements in the establishment, monitoring, and auditing of budgetary accounts.

Despite the housing finance reforms, the fiscal implications of higher interest rates on the stock of cheap pre-1989 housing loans continued to constrain monetary policy. The overall level of general government expenditures—at more than 60 percent of GDP in 1989—reflected excessive state intervention in the economy and required a heavy tax burden. Social security expenditure (about 17 percent of GDP in 1990), in particular, was poorly targeted, subject to acknowledged abuse, and—given current demographic and economic projections and despite excessively high contribution rates—actuarially unsound.

A radical transformation of public finances is a key element of the Government’s strategy to reduce the State’s role in the economy. Important steps were taken in the 1991 budget. Subsidies—including consumer, producer, investment, and housing subsidies—are planned to decline to 7 percent of GDP in 1991, from approximately 9 percent in 1990. Interest rates on pre-1989 housing loans have been raised substantially, generating additional payments from each borrower of Ft 1,500 a month, or substantial repayments of old loans with a 50 percent discount. This measure was challenged as unconstitutional on the grounds that it unilaterally changes the terms of old contracts; it was recently ruled constitutional by the Constitutional Court. Investment expenditures by the budget were reduced by about 20 percent. Measures are also planned that will reduce the overall size of public administration, while increasing resources for such essential sectors as tax administration.

The Government is preparing a new Budgetary Framework Law, which is intended to define the functions of central and local governments, establish procedures for expenditure control, and improve fiscal monitoring. The Government’s medium-term objective is to reduce substantially state budget spending relative to GDP. This will require an overhaul of the social security system. The Government intends that social systems be supplemented by private insurance, with an important role for nongovernment institutions. It is currently preparing a “white paper” for presentation to Parliament with its proposals for the comprehensive reform of social security programs. Already in 1991, the authorities have acted to increase cost awareness among health consumers and to introduce some reforms of the pension system.