Chapter

27 Hungary

Editor(s):
Teresa Ter-Minassian
Published Date:
September 1997
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Author(s)
Mark Lutz Edgardo Ruggiero Paul Bernd Spahn and Emil M. Sunley

Prior to 1990, Hungary had a unitary and centralized system of government with lower tiers having little independent revenue or expenditure autonomy. Hungary has since reformed its Constitution and decentralized many public functions in order to render government more responsive to its citizens. Lower tiers of government have been given significant scope for self-rule, but the basic precept assigning to the central government a dominant role has been retained.

In a series of legislative acts and administrative reforms in 1990 and 1991, Hungary established the legal framework for a two-tier system of government under which municipalities are constitutionally independent entities and have responsibility for their jurisdictions.1 These laws assign expenditure and revenue functions to the lower level of government, and they specify the system of intergovernmental relations, including the system of transfers from the central budget.

Hungary’s reform of the government sector is typical for most former communist countries on their way toward a market economy. After a period of centralized planning and decision making, the delivery of public functions in education, health, and social welfare has been devolved to lower levels of government in order to render the provision of public services more responsive to local demand, to strengthen the accountability of local politicians, to mobilize initiatives at the municipal level, and to enhance general economic welfare. Hungary may serve as an example to illustrate the main thrust of such reforms and the various problems encountered by formerly communist countries on the pace of transition.

Structure of Government

The current structure2 of Hungarian government is extremely decentralized. At the central government level, there are 29 budgetary chapters, comprising the spending ministries, offices of the President and Prime Minister, parliament, and other agencies. In 1995, attached to these chapters were 1,424 central budgetary institutions, excluding those pertinent to defense and related activities. Of these, 697 had budgetary autonomy. In addition, at the central government level, there were 29 extrabudgetary funds administered by the budgetary chapters,3 and two self-governed social insurance funds, which were responsible for health care and pensions.

At the municipal level, there were 3,168 governing bodies, which in turn operated, in 1995, 13,627 local budgetary institutions (that is, service providers such as elementary schools, clinics, trash collection services, hospitals, and universities in large municipalities) of which 7,972 had budgetary autonomy.4 Local governments are now directly responsible for most decentralized functions.

Budapest itself enjoys a special status. The municipality executes functions that affect the whole or a large part of the capital. But, in addition to the municipality, Budapest is divided into 22 autonomous districts directly responsible for providing local services.

General government financial flows are also quite decentralized in Hungary. The consolidated budget and intergovernmental flows of funds are shown in Table 1. The state budget acts as a partial clearinghouse for the majority of all centrally imposed tax revenues, and finances producer and consumer subsidies, family allowances, centrally decided investments, debt servicing and transfers to other components of the general government. The central budgetary institutions also receive payments and fees for services, some of which are commercial in nature. The extrabudgetary funds receive earmarked tax revenues (such as petrol excises to the road fund), payroll contributions (for example, to the solidarity fund for unemployment compensation), earmarked privatization revenues, and other payments. The social insurance funds collect payroll contributions, and local governments collect fees and revenues from a number of local taxes. The official presentation of budgetary data by the authorities fails to consolidate a large number of intragovernmental fiscal transactions (for example, contributions by budgetary institutions to the social insurance funds), thereby overstating significantly the size of the government relative to the total economy. Even after netting out known intragovernmental transactions, considerable double counting is thought to remain.

Table 1.Hungary: Consolidated General Government Budget, 19951
Central Government
TotalTotalState budgetCentral budgetary institutionsExtra-budgetary fundsSocial securityLocal Government
(In billions of forint)
Revenues2,825.32,487.61,582.5149.9144.4610.8337.8
Taxes2,126.41,983.91,318.098.0567.9142.5
Income taxes498.6405.0405.093.6
Payroll taxes628.5628.560.6567.9
Taxes on goods and services999.3950.4913.037.448.9
Nontax revenues699.0503.7264.5149.946.442.9195.3
Privatization receipts155.9150.0150.05.9
Other543.0353.7114.5149.946.442.9189.4
Expenditures3,007.52,312.7989.8514.5119.2689.1694.8
Current expenditures2,714.62,137.6881.6464.7105.1686.2577.1
Wages and salaries459.0210.3208.51.8248.7
Other goods and services521.9260.9146.762.732.319.1261.1
Interest payments513.6513.6502.910.7
Subsidies and transfers1,220.11,152.8231.9193.560.3667.167.3
Capital expenditures292.8175.1108.249.814.12.9117.8
Fixed capital formation191.8102.748.449.81.62.989.1
Capital transfers101.072.459.912.528.7
Subbalance−182.1174.9592.7−364.625.2−78.36−357.0
Plus: Net transfers to State budget−320.2−818.4466.531.7320.2
Central budgetary institutions−6.011.5−100.92.580.76.0
Extrabudgetary funds−7.146.6−69.015.27.1
Social insurance fund−127.146.5−173.6127.1
Local government105.21.0104.2−105.2
Balance−182.1−180.3−213.294.2−9.5−51.7−1.9
Financing182.1180.3213.2−94.29.551.71.9
Domestic bank financing−94.29.551.71.9
Domestic nonbank financing
(In percent of GDP)
Memorandum items:
Revenue47.541.926.62.52.410.35.7
Expenditure50.638.916.78.72.011.611.7
Subbalance−3.1−2.910.0−6.10.4−1.3−6.0
Balance−3.1−3.0−3.61.6−0.2−0.9
Sources: Hungarian authorities; and authors’ estimates.

Authors’ estimates based on data contained in August 1996 Ministry of Finance submissions to parliament.

Sources: Hungarian authorities; and authors’ estimates.

Authors’ estimates based on data contained in August 1996 Ministry of Finance submissions to parliament.

The necessity to circulate information between the central government (in particular the Ministry of Finance and the Ministry of Interior) and local and county governments has led to the creation through a government decree of administrative bodies, called TAKISZ, whose basic functions are established by government decrees and parliamentary decisions. The TAKISZ are attached to the general directorate of the Ministry of Interior, and their operation is assured jointly by the Ministry of Finance and the Ministry of Interior. These institutions support local governments in preparing their budgets in line with national framework legislation and provide technical assistance in all daily operations of a financial and economic nature. Furthermore, they collect and consolidate statistical information on the lower tiers of government, as needed for setting national priorities and for intergovernmental fiscal relations. They also provide other types of assistance to local governments—for instance, regarding tax collection, social policy, accounting, and local services, either free of charge or on a fee-for-service basis.

Intergovernmental Arrangements

Expenditure Assignments

As is typical for unitary states, all state functions are discharged by the central government unless explicitly stated otherwise by the Constitution or by law. The Local Self-Government Act of 1990 transferred a number of important public functions to the lower tiers of government. Moreover, the new local governments have responsibility for many areas that were previously assigned either to the central government or to companies and cooperatives. However, the welfare system remains highly centralized and offers relatively high levels of social benefits. Generous child support, early retirement schemes (with the result that one quarter of adults are pensioners), and unemployment assistance (that can be taken up immediately by school leavers) put a heavy burden on the central budget. This entails high nonwage labor costs in the form of social security contributions, which rank among the highest in the world (although these were cut somewhat in 1996–97) and represent a significant burden to the economy. The size of the overall public sector is large in Hungary, compared with other European countries. General government expenditures (including social security) were about 51 percent of GDP in 1995. Nevertheless, this is about 10 percentage points of GDP lower than in the early 1990s.

The importance of local spending has been growing since the reforms. In 1995, local governments spent roughly Ft 700 billion5 (or about one-fourth of total government expenditures), which illustrates the importance of this sector. Main areas of local responsibility are education (28 percent), health (17 percent), and housing (10 percent of total local government outlays), as well as other social and cultural services (Figure 1). A significant part of local spending is devoted to creating and improving local infrastructure through investments (15 percent of total outlays).

Figure 1.Hungary: Local Government Expenditure by Sector of Activity, 1995

Sources: Hungarian authorities and authors’ estimates

The local governments are self-governing organizations, which creates some tensions with the central government, especially for those services (such as health, welfare, and education) whose delivery, financing, and policy functions are assigned to multiple levels of government. For example, in 1995, the central government (which sets general policies in the area of social expenditures) decided to reform the health delivery system and to reduce hospital capacity by around 10,000 beds—as a first step toward rationalization of the supply of curative health services. However, the local governments are the owners of several hospitals (the remaining ones are owned by the central budgetary institutions); therefore, on constitutional grounds, they are the only ones who ultimately have to approve the reduction in the number of beds in their own territory. The local governments have resisted the closure of hospitals beds, leading to a delay in the reduction in hospital capacity.

Tax Assignments

Hungary has introduced, through reforms in 1988 and 1989, a modern tax system consisting of a value-added tax (general turnover tax), a personal income tax, and a business profits tax. Moreover, various excises and fees are associated with specific transactions. All these taxes are national taxes, based on uniform rules, and their proceeds accrue to the central government, with the exceptions of a share in personal income tax collected by the central government, but distributed to municipalities, and a small amount of shared motor vehicle taxes.

Most national taxes are administered by the central government in Hungary under the Tax and Financial Audit Board (APEH), which has regional offices in each county and in Budapest. Within the Ministry of Finance, the Customs and Excise Police (VPOP) administers customs duties, domestic excises, as well as value-added tax and excises payable on imports. In addition, local tax offices and county directorates administer and collect local taxes.

The Act on Local Self-Government defines local tax competence for taxes on local properties, communal taxes, and local business taxes. In 1994, only about half of the Hungarian local governments imposed some, albeit not all, local taxes; the other half imposed no local taxes. Local taxes raised Ft 48.9 billion—or 6.1 percent of total nonconsolidated revenue of local governments in 1995.6 While the overall tax ratio is high in Hungary, the local tax burden is almost negligible (without fees, 0.8 percent of GDP in 1993).

The tax on property is divided into a tax on buildings and a tax on unimproved land. There is an option between a physical tax base (square meters) and a valuation base, but the latter is rarely used. Generous exemptions—25 square meters a person, for example—exempt most households from these taxes. There is a maximum limit on the annual rate chargeable.7

The “communal taxes” include a tax on tourism (based on guest nights and on rented or owned secondary dwellings), and lump-sum taxes levied on local residents (tenancy rights or rental contracts) and on local firms according to their average number of employees. The maximum lump-sum tax is Ft 3,000 per tenancy right (equivalent to US$24), or Ft 2,000 per employee.

The local business tax is now the main own source tax for local governments. In 1995, it raised Ft 37.6 billion (0.7 percent of GDP), with about half of the revenue accruing to the Budapest municipality. This tax attempts to capture local commercial activity and is essentially based on net turnover with certain qualifications. The entrepreneur liable for the tax can be a private person, a legal entity, or an organization (such as churches, state enterprises, and housing cooperatives). In small municipalities (as defined by national rules), retail trade is specifically exempt (except for the sale of liquors).

The tax base is normally “net sales revenue of products sold and services provided, reduced by the purchase value of the goods sold and the value of services provided by subcontractors” (Section 39(1) of the Act). The deduction of the costs for goods purchased is limited to those sold without transformation; in the case of subcontracted services, the deductibility applies only to those services that directly form part of the service provided “as such.” If goods are purchased and transformed (as in manufacturing), and if services enter the price of the product sold or the service provided only indirectly (as legal services for a computing firm), the deductibility of such costs is denied. A fortiori, investment expenditures cannot be deducted.

In the case of financial institutions, the tax base is gross turnover—the total of interest received in the case of banks and the total of the technical revenue in the case of insurance companies. Neither deductions for the banks’ interest payments on liabilities nor for the insurers’ payments to settle claims are allowed. This puts financial institutions at an unequal footing compared with other commercial enterprises.8

The maximum tax rate of the business tax is 0.8 percent (or Ft 5,000 a day in the case of occasional activities).9 Local governments can vary the rates according to economic activities as long as the rate remains below the ceiling. They can also grant exemptions and deductions from the tax base through local regulations as long as these are general, specified by economic activity, for instance, and not for particular firms. There is no minimum rate for the business tax, and a local government may also choose not to levy the tax at all.

The main issue relating to own local taxes is their limited revenue significance. Own local taxation has to be strengthened in Hungary in order to mobilize fully the potential of this tier of government. This could partly be achieved through the business tax and the introduction of modern property taxation. Also, the business tax base has to be streamlined and standardized, in order to mitigate locational distortions and cascading, in particular with regard to financial operations. In addition, a local income tax as exists in Scandinavian countries, which is collected by the central government, could help to boost local revenue and to foster local accountability at the same time.

Revenue Sharing

Own local tax revenue is now complemented by a share of the personal income tax to local governments, which constitutes essentially a transfer from the central government. In 1995, 35 percent of the personal income tax collected by the central government was returned to local governments;10 of this, a 29.5 percent share was returned to local governments on a derivation basis, and another 5.5 percent share was transferred on an equalization basis.11 In addition, fees collected by counties are subject to sharing with the central government with some horizontal equalization among counties.12

These transfers from the income tax share are effected in 12 monthly installments with, owing to administrative difficulties, a two-year lag that, given inflation, reduces the real value of the transfer and increases the reliance on additional intergovernmental grants. A period of two years is, in fact, needed by TAKISZ to calculate the shares for each municipality on the basis of the income tax data provided by APEH. The two-year lag provides a “buffer” for those municipalities where an important local employer may cease his business operation. A further rationale for the two-year lag is, therefore, that a cashflow-oriented, personal income tax share would be procyclical and would cause an immediate disruption of local services on top of a local unemployment problem.13

The government plans to increase the local governments’ share to around 40 percent by the year 2000 and to reduce the portion shared on a derivation basis to 20 percent. The derivation-based portion of the personal income tax sharing scheme benefits, of course, Budapest, where the revenue potential of this tax is greater. Any variation in the share must thus have uneven horizontal distribution effects among local jurisdictions, given differences in their economic potential.

The main issue with the shared tax is that it is a grant from the central government (albeit out of an earmarked revenue source) and not a local revenue source. To increase accountability of local governments and to improve local flexibility to meet the demands for services, each local government could be given the right to apply its own tax rate on the national income tax base. A local income tax surcharge would give localities a powerful revenue tool and increase the link, at least at the margin, between local public services and taxes payable. This would not necessarily diminish the importance of any equalizing supplementary grants for poorer municipalities.

Grants

Given the limited significance of own local taxes and personal income sharing in financing local budgets, the dependency of the municipal sector on grants remains high in Hungary. Grants from the central government, extrabudgetary funds, and the social security funds, of which the normative grant is by far the largest, provided about 64 percent of the recurrent finance available to local governments in 1995 (Figure 2).

Figure 2.Hungary: Local Government Revenue by Type, 1995

Sources: Hungarian authorities; and authors’ estimates.

The normative grant is intended to address the vertical and horizontal imbalances of the present fiscal system and to attenuate the consequences of the fragmented local government structure.14 It is based on simple indicators of expenditure needs such as the number of inhabitants, or indicators of capacity use (such as the number of care days for the elderly, children, the homeless, or the mentally ill). In 1994, the normative grant consisted of 27 norms, as shown in Table 2. For each norm the budget specified a unit cost; for example, Ft 41,000 per elementary school student or Ft 250 per capita for cultural activities. The normative grant for a municipality is obtained by multiplying the number of units for each norm by the unit cost, and then summing up the result for the 27 different norms. The grant can thus be considered to be closed-ended. This puts a lid on local budgets and constitutes an improvement over the prereform negotiated gap-filling approach. Although based on objective parameters for distribution, the normative grant can be used at the discretion of local governments once they fulfill these criteria. The formula is revised each year.15

Table 2.Hungary: The 27 Normatives in 1994, Norm Costs and Actual Costs
Type of NormativeNorm UnitReceiving Local AuthorityNorm Unit Costs, 1994

(In forint)
Average Coverage

(In percent)
1. Lump-sum grant to village municipalitiesPer villageResidence2,000,000
2: Operational costsPer capitaResidence3,820
3. Underdeveloped municipalitiesPer capitaResidence1,200
Municipalities in underdeveloped areasPer capitaResidence2,300
4. Public housing20–30 years oldResidence4,680
5. Matching per forint in tourist taxResidence2
6. Social subsidyPer capitaResidence2,500–4,700
7. Juveniles and orphansPer caseProducer245,00063.4
8. Social institutionsPer caseProducer186,40068.8
9. Day care, socialPer caseProducer30,85041.9
10. Hostels for elderly, homeless, etc.Per caseProducer87,00037.3
11. Temporary for homelessPer caseProducer78,00050.0
12. Children, multi-handicapped or mentally illPer caseProducer275,00071.9
13. Mentally ill adultsPer caseProducer234,00086.4
14. KindergartenPer caseProducer27,50036.1
15. Kindergarten, ethnicPer caseProducer5,500
16. Elementary schoolPer caseProducer41,00066.0
17. Art trainingPer caseProducer25,10083.7
18. Schools for invalidsPer caseProducer70,700
19. GymnasiumPer caseProducer62,50079.3
20. Special secondary schoolPer caseProducer66,00068.0
21. Vocational schools, theoryPer caseProducer42,10093.8
22. Vocational schools, practicePer caseProducer40,60042,2
23. Bilingual schoolsPer caseProducer16,500
24. School boardingPer caseProducer66,000
Elementary schools53.8
Secondary schools70.6
25. SportsPer capitaResidence50
26. Cultural activityPer capitaResidence250
27. County and capital operations, library, theater, etc.Per capitaResidence490
Sources: Hungarian authorities; and authors’ estimates.
Sources: Hungarian authorities; and authors’ estimates.

In addition to normative grants, local governments receive targeted grants for investment purposes, and they obtain direct transfers from social security funds. The latter are mainly expenditure related and thus constitute “soft” financing, although cost coverage is below 100 percent. Other small transfers include grants for distressed localities.

While own revenues and the derivation share of personal income tax exhibit no regional redistribution effects among local government (since they are all on a derivation base) the normative grants, as well as the equalization portion of the personal income tax share, exert important equalization effects in favor of poorer municipalities.

Horizontal equalization schemes have to deal with horizontal redistribution in order to equalize (1) standard own taxable capacity and (2) standard expenditure needs reflecting also the effects of population density and agglomeration on local expenditure needs. Some countries have formally adopted this approach by equalizing the difference between standard own fiscal capacity and expenditure needs and correcting it by factors that account for density and agglomeration effects.

In Hungary, where own fiscal capacity of local governments is low, no attempt to standardize local government budgets is made. However, the grants system exhibits similar effects to that under an explicit standardized budget approach. For instance, the grants to disadvantaged areas and the equalization-based portion of the personal income tax sharing scheme are revenue equalizing, while norms based on general need criteria equalize expenditure needs. The derivation-based portion of the personal income tax sharing scheme, which benefits higher-income agglomerations, in particular Budapest, may be understood as a correction for agglomeration effects. It constitutes a bonus with regard to fiscal capacity, which is correlated with higher income levels.

As illustrated in Figure 3, the overall importance of grants transferred solely for the purpose of fiscal capacity equalization is low in Hungary. In 1995, only 4.1 percent of total grant money was distributed according to this element. Also, the general importance of need-oriented grants remains limited, although it is significant for the poorer jurisdictions. The majority of the grant money is disbursed on the basis of capacity-use or expenditure-related criteria. Capacity-use and expenditure-related (gap-filling) grants are appropriate to the extent that lower-tier public services are “mandated” by the central government or the social security funds. However, those types of grants are inappropriate for financing “own policies” of local governments. Such grants tend to relax the budget constraint at the lower level of government. They afford incentives to provide subsidized services, while they fail to exert control on production costs and indeed do not force the local government to evaluate the need for the service against its cost. Needs-oriented grants tend to exert a stronger discipline on local government budgets. As decentralization is intended to strengthen self-rule at the lower tiers of government, while ensuring compliance with macroeconomic constraints, this would call for a reduction of capacity-use and expenditure-related grants in favor of transfers that are based on objective needs criteria.

Figure 3.Hungary: Transfers to Local Government Classified by Equalization Effect, 19951

Sources: Hungarian authorities; and authors’ estimates.

1 The classification of transfers is made according To the following principles. Fiscal capacity equalization corresponds to the transfer to disadvantaged areas and the 5.5 percent equalization portion of the income tax share; the fiscal capacity bonus is personal income tax sharing based on the derivation principle. Needs-oriented and capacity-oriented grants together form the normative grant and other grants. Those elements that are based on standard criteria outside the control of local government (essentially the lump-sum and residence-based elements of the normatives) are classified as needs oriented. Normative grants received by producing institutions are all classified as capacity oriented. All social security Transfers are classified as expenditure oriented.

Borrowing

All governments in Hungary are in principle free to finance their budget deficits through capital markets. The National Bank of Hungary was granted legal independence in December 1991. However, it may provide credits paying market-related interest rates to the central government in an amount not exceeding 3 percent of annual revenues.16 Moreover, the Act on the Central Bank was amended in 1993 to allow for a short-term liquidity credit facility, which may not exceed an additional 2 percent of projected annual budget revenues and which may not last for more than 15 days.17

Although Hungarian municipalities can borrow on the private market without central government interference or control, most local governments are reluctant to incur debt, even for capital outlays where revenue could be generated in the form of user charges. This reflects conservative and prudent behavior, but also the tradition of the former system in which local councils had no discretion in borrowing. Total local sector borrowing (including the issue of municipal bonds) was Ft 19.7 billion (or 2.5 percent of their nonconsolidated expenditures) in 1995. Larger villages and towns and, notably, the Budapest municipality and its districts resort to borrowing more than smaller villages and cities. Only the capital city is able to mobilize significant funds through issuing bonds. This also reflects the fact that local governments face varying obstacles when entering this market.

At present, there seem to be no significant risks in excessive borrowing and indebtedness by lower tiers. Nevertheless, Hungary may want to limit long-term borrowing by local governments to nonoperational purposes and primarily to capital formation that can be financed by user charges.18 In the medium term, more attention must be given to financing capital expenditures of local governments. For instance, local governments, at this stage, seem not to realize fully the relationship between local capital formation and its financing. There is no capital budgeting that would allow them to take a longer-term perspective extending beyond the annual budget period.

Budget Formulation and Implementation

The present system of budget preparation, execution, and cash management is the result of reforms—beginning as early as the New Economic Mechanism introduced in 1968—that permitted increasingly decentralized decision making on the part of budgetary institutions’ managers, and of recent requirements included in the Law on Public Finances, which took effect in July 1992. This increasing decentralization has led to a proliferation of central and local budgetary institutions. The central authorities, both in the Ministry of Finance and in the spending ministries, have little timely information and limited effective control on the operations of these decentralized budgetary institutions. The separation of the central government budget into subsystems and the related pervasive earmarking of revenues has tended to promote fiscal rigidity, both in the preparation of annual budgets and in their execution during the year. Moreover, the budgetary institutions have been allowed to engage in activities of a commercial nature to supplement transfers from the state budget (for example, note the large share of local government revenues from user charges in Figure 2). These commercial activities are largely inconsistent with the role of government in a market economy and can in some circumstances be regarded as inhibiting the growth of the private sector.

Conclusions and Policy Implications

Macroeconomic Management

Despite the substantial reduction in recent years of Hungary’s revenue and expenditure shares in GDP, they remain above the average of member countries of the Organization for Economic Cooperation and Development. Although these are likely to be substantially overstated by nonconsolidated activities among government agencies, these ratios easily exceed those recorded in Western European economies when they were at Hungary’s present level of development. This remains a legacy of the old central planning system. Therefore, in addition to maintaining the sustainability of its external and fiscal imbalances, Hungary must continue to reduce the scale and scope of its governmental activities, increasingly relying on the market economy to provide, generally more efficiently, goods and services presently provided by the state. This will allow for an eventual reduction in tax rates, especially social insurance contribution rates that retard growth in legitimate economic activity.

It is essential that policies at the local government level support the general effort to contain the consolidated budget deficit and that budget constraints are enforced at all levels of government. The relationship between the central government budget and the local government sector and its development bears on macroeconomic stabilization in many ways.

First, transfers to local governments and their implicit incentive effects are crucial for macroeconomic management. Although the central government has abandoned the negotiated “gap-filling” approach of the previous system and emphasizes local self-government through own taxation and the provision of needs-related general revenue grants, the importance of capacity- and expenditure-related normative grants remains high. The open ended character of many elements of the grant system may still create risks for fiscal policy, in so far as it establishes incentives for excessive demand for local services and, therefore, for aggregate demand. For example, schools and institutions have an incentive to attract—and self-generate—local demand, given that the average cost coverage of the grants to these recipients is quite large (Table 2, last column). Moreover, the system lends itself to corruption, as attendance records to schools and institutions (which represent the bulk of the specific norms within the normative grant) could be artificially inflated by the recipient, in order to qualify for larger grants. Grants for social, health, and educational services are still perceived as “entitlements” by local government officials.

Second, an efficient provision of local public services calls for a higher proportion of local taxation to strengthen accountability, efficiency, and flexibility at this level. This is the essence of decentralization of the public sector. The central government may have to make room for local taxation, particularly as the total tax burden is high in Hungary. However, if local governments—unaccustomed to revenue-raising responsibilities under the previous system—make insufficient use of their scope for own taxes, pressures on the central government could result that could exacerbate the fiscal position of the consolidated government. Though the recently introduced limits on bank borrowing by local governments are effectively nonenforceable (see section on Intergovernmental Arrangements), the risk of local governments incurring excessive debt is not large, because of traditional reluctance in incurring debt. However, the risk of excessive debt creation lies not so much with the municipalities themselves, but with the local budgetary institutions with budgetary autonomy.19 For example, hospitals (many of which are owned by the municipalities) have accumulated large debts with suppliers. At the end of 1996, these debts were cleared through loans by the health fund (which is part of the central government) to the hospitals. Though formally the hospitals have to repay these loans, it is unclear where they will find the resources to do so. Through this clearing operation the central government has bailed out the institutions delivering public services at the lower level of government, and effectively sent the message that there is no hard budget constraint on these institutions. It is therefore important to create adequate incentives (in particular through a hard budget constraint and the establishment of a “no bailout clause”) for the local authorities and institutions to exercise their revenue-raising capacities, including through wider recourse to user fees.

Structural Reform

Hungary has made significant progress in adapting its structure of government to the challenges of a market economy and to democracy. It was indeed the first country of formerly communist rule to decentralize government and to adopt a system based on the Local Government Charter of the Council of Europe. Hungary is still in the process of consolidating and furthering these achievements, and the benefits will only be reaped in the longer run. Apart from the need to improve the political and administrative machinery of the public sector, the structural economic reforms should focus on the following areas.

Local taxation. Local tax potential is poorly exploited in Hungary. In order to improve the efficiency of local government, local taxation has to be strengthened. A main contribution could come from an own local income tax, which could be collected as a piggyback tax in conjunction with the national income tax. In order to keep the global tax ratio unaffected by this structural policy, the central government would have to make room for such a tax. Also, the local business tax could be exploited more fully, although there are limits imposed by the need to contain distortions of remaining cascading effects and to keep Hungarian companies competitive on international markets. In the longer run, a local property tax and the greater use of user charges could also contribute to improving local finance.

Budgetary procedures. Although expenditure assignment among Hungarian government institutions follows international practice and is based on the principles of federalism, difficulties remain. These are clearly related to the proliferation of autonomous budgetary entities and the resulting complexity of budgetary procedures. At present, it is difficult to obtain a clear picture of government operations owing to double counting of intergovernmental flows of funds and the absence of economic and functional classifications of government expenditures. The complexity of budgetary procedures also affects accountability, as it is difficult to identify clear responsibilities despite explicit definitions in the Constitution. This is particularly important for revenue responsibilities as intergovernmental grants are still widely perceived as “entitlements.” As to the expenditure side of budgets, a clearer separation of investment from operational outlays, and medium-term costing of investment projects would help improve choices in this important area.

Privatization and local entrepreneurship. Related to budgetary reform of the public sector is the fact that many Hungarian municipalities engage in entrepreneurial activities by administering state assets of the previous regime that had been handed over to them for privatization. This is a temporary problem and may even be appropriate for some state assets (like housing); it clearly implies severe risks for local budgets where municipal activities extend to production and commerce. Business activities of local government also run counter to national privatization policies, and they impede the development of a private sector, as public entities (which could benefit from implicit bailout) compete with firms without such guarantees. There is also a conflict of interest in that local business activity may be subject to tax. It is essential that business activities of local government should be restricted to basic utilities (water, sewerage, waste disposal), and that these activities be formally separated from public service delivery and administration.

Grants system. The Hungarian grants system is still characterized by a significant reliance on capacity- and expenditure-related transfers that resemble the previous gap-filling approach, although cost coverage is now only partial. A reformed system of intergovernmental grants should take into account both expenditure needs and tax capacity in order to equalize the resources of municipalities. Needs-oriented grants for local government are typically more efficient as they can be designed independent from local decision making and strategies. Their amount should also be positively related to the full utilization of the local tax capacity, in order to establish disincentives for municipalities to engage in tax competition. Whether Hungary should reinforce the equalization effect of the present grants system or foster the higher-income municipalities (such as Budapest) as centers of growth is essentially a political question related to value judgments on horizontal regional equity and to development strategies.

Coordination. The proliferation of local governments and autonomous budgetary units makes coordination of policies necessary. TAKISZ was set up to respond to certain information and coordination needs, yet it has no clear mandate for fostering cooperation and coordination of local policies. The counties are not able to respond to these needs, and municipalities strongly resent interference in their newly won self-rule by the Ministry of Interior. Partly for these reasons, the TAKISZ network has not fully developed an information system capable of providing up-to-date information on the budgetary and financial position of the local governments. The first entities that would stand to benefit from a more efficient network would be the municipalities themselves. In fact, the two-year lag currently needed by TAKISZ to compute the personal income tax shares for each municipality could be considerably reduced if cooperation between TAKISZ and the local governments and the tax authorities were enhanced.

Coordination of local policy can be achieved in various ways. One form is the regional consolidation of municipal jurisdictions, which is always possible on a voluntary basis. Municipalities could be encouraged through specific purpose grants to establish collaborative forms of supply through special purpose administrative units with clearly defined functions. It is indeed more efficient to consolidate the supply of certain local functions with spillovers outside the boundaries of the municipality where they are located (such as curative health care and nonelementary education). The establishment of these entities would not result in an increase in local government employment; rather, it may yield to its reduction, as the rationalization of supply may involve a consolidation of existing manpower. These entities could be financed through user charges, and through the sharing of costs by those local governments whose residents benefit from their services.

Law on Local Self-Government (1990), Law on the Capital (1991), Law on Local Taxes (1990), and Property Transfer Act (1991). Moreover, the Law on Public Finances (1992) enumerates the rights and obligations of local governments regarding budget preparation, monitoring, control, and reporting.

For a further discussion of the structure of government in Hungary see Lutz (1992), Bird and Wallich (1992), and Bird, Péteri, and Wallich (1995). Data in this chapter refer to 1995, unless otherwise stated.

In 1996, there were 30 budgetary chapters and 1,343 central budgetary institutions (of which 659 with budgetary autonomy); the number of extrabudgetary funds was reduced to six.

In 1996, there was almost no change in the number of municipalities (3,169), although the number of budgetary institutions operated by the local governments declined to 13,509, of which 7,801 had budgetary autonomy. Prior to 1986, the budgets of local councils, as they were then referred to, were consolidated with the state budget and, therefore, approved on a gross basis. Beginning in 1989, the activities of the social insurance fund were separated from the state budget, and the fund was separated into the two social insurance funds in 1994.

Included is about Ft 127 billion in expenditures on local health care financed by the health fund. Local expenditures also include social insurance contributions totaling Ft 108 billion and significant value-added tax payments, which are received by other organizations within the general government—the social insurance funds and the state budget, respectively.

Inclusive of vehicle tax (Ft 2.5 billion).

This limit is Ft 300 per square meter or—in the case of an ad valorem base—3 percent of the adjusted market value.

In Budapest, for instance, more than half of the revenue of the business tax is obtained from the financial sector.

The ceiling was raised to 1.2 percent in 1996.

Prior to 1995, for the poorer municipalities, there was a minimum per capita guarantee for the personal income tax share. Any shortfall of personal income tax revenue collected with respect to the per-capita minimum was compensated by a separate supplementary grant with regional equalization effects. The supplementary grant was abolished in 1995, with equalization transfers subsumed into previously existing grants to disadvantaged areas.

In 1990, local governments had received 100 percent of 1988 personal income tax collections. The local governments’ share was then reduced to 50 percent in 1991 and 1992, and to 30 percent in 1993 and 1994. In 1996, the income tax share was raised to 36 percent; of this, 25 percent was distributed on a derivation basis and 11 percent on an equalization basis.

As a rule, 50 percent of the fee remains at the county level, and 50 percent is transferred to the central government. This applies fully for fees collected on properties located in the county capital. In the case of Budapest, the fee accrues to the metropolitan government, not the districts. The horizontal equalization scheme applies to properties not located in the county capital. In this case, 30 percent of the entitlement is allocated to the county government while the remainder is divided equally among all counties. Budapest does not participate in this equalization mechanism.

One may argue that it has the opposite effect on localities with growing economic activities and related demand for local services, but in this case the municipality may be able to borrow against expected cash flow from the tax.

This is not the case for the norm that matches revenue from the tourism tax (Table 2). Budapest, already the municipality with the largest income tax base, is the main beneficiary of this matching component of the normative grant.

In terms of the classification of grants presented in Chapter 1, the normative grant can be regarded as being made up of subgrants belonging to different categories. The norms 1 through 3 identify transfers that are essentially general purpose grants, as they are given to—often poor—municipalities to satisfy general funding needs. The norms 4, 46, and 25 through 27 identify block grants, as they are given to municipalities to deliver specific services (such as educational and mental institutions) to cover a portion of the production cost. These are open-ended specific grants, as the amount transferred increases with the number of students enrolled in schools or people housed in institutions or nursing homes. Within the specific grants, norm 5 is an open-ended matching grant.

This amount was applied in 1995 and 1996, with higher but declining amounts (unlimited in 1992, 5 percent in 1993, and 4 percent in 1994) available in earlier years. However, in 1994 the National Bank was obliged through the Annual Budget Law to purchase government securities in an amount equivalent to 7.1 percent of budgeted revenues.

The Central Bank Act was amended in 1996 to enhance independence of the National Bank. The new legislation, inter alia, eliminates direct credit to the government—with the exception of the liquidity facility.

In 1996, a law specifying a ceiling on the amount of bank borrowing of local governments, expressed as a percentage of own revenue, was adopted. However, it is not certain how binding this ceiling is. Local budgets violating the ceiling can be approved; it is then up to the prefect (the representative of the central government at the local level and an employee of the Ministry of Interior) to ask in writing to the concerned local government to change its budget or borrowing plans. If such suasion does not work, the prefect can then cite the local government in an administrative court, whose verdict may arrive well after the end of the fiscal year.

This problem has arisen also in Italy, where the overspending at the subnational level has been generated by the local institutions delivering health and transportation services, rather than by the regions or the municipalities themselves (see Chapter 11).

References

    BirdRichard andChristineWallich1992“Financing Local Government in Hungary,”Policy Research Working Papers, Public Economics, WPS 869 (Washington: World BankMarch).

    BirdRichard M.GáiborPéteri andChristine I.Wallich1995“Financing Local Government in Hungary,” in Decentralization of the Socialist Stateed. by Richard M.BirdRobert D.Ebel andChristine I.Wallich (Washington: World Bank).

    EbelRobert D. andPeterSimon1995“Financing a Large Municipality: Budapest,” in Decentralization of the Socialist Stateed. by Richard M.BirdRobert D.Ebel andChristine I.Wallich (Washington: World Bank).

    LutzMark1992“Fiscal Structure and Development in Hungary,”Volume IIAnnex 2 inHungary: Reform of the Public Sector (Washington: World Bank).

    Ministry of Finance1996Törvényjavaslat A Magyar Köztársaság 1995 Évi Költ-ségvtésének Végrehajtásáról (Budapest).

    O’TooleLaurence J. Jr.1994“Local Public Administrative Challenges in Post-Socialist Hungary,”International Review of Administrative SciencesVol. 60 pp. 291304.

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