V. Reform of Public Finances, 1994–97
Author: Mr. Edgardo Ruggiero
Language:
English
Keywords:
OP; enterprise; deficit; public finance; government employment; excess demand; outpatient care remuneration; progressive tax; Pension spending; Social security contributions; Pensions; Tax allowances; Eastern Europe
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Abstract

During 1994–97, Hungary implemented far-reaching structural changes in the area of public finance, and has achieved both a considerable contraction in the size of the government and sizable primary surpluses. This chapter first describes the main institutional characteristics of the government sector and the principal issues that policymakers had to address; then it reviews the reforms and their effect on fiscal indicators.1

During 1994–97, Hungary implemented far-reaching structural changes in the area of public finance, and has achieved both a considerable contraction in the size of the government and sizable primary surpluses. This chapter first describes the main institutional characteristics of the government sector and the principal issues that policymakers had to address; then it reviews the reforms and their effect on fiscal indicators.1

Size and Composition of Government and Main Structural Problems

In 1994, the state of public finances was characterized by both a large deficit and revenue and expenditure ratios that were high by international standards. As discussed in Chapter IV, the primary balance was negative (Figure 5.1), and in the presence of a sizable public debt, the underlying dynamics of the debt-to-GDP ratio was not sustainable. The size of the central government was also particularly large, in terms of both expenditure and revenue ratios to GDP. Total revenues (excluding privatization receipts) were 48¼ percent of GDP, while total expenditures were 55½ percent of GDP. Such expenditure ratios are large compared with the OECD average (38½ percent).2 Government employment, as a percent of total employment in the economy, was also larger than in most OECD countries in the early 1990s (Figure 5.2). Also, Hungary had a relatively large civil service compared with other central and eastern European countries (Figure 5.3).

Figure 5.1.
Figure 5.1.

Consolidated Central Government Primary Balance 1

(In percent of GDP)

Source: Ministry of Finance.1 Includes the central budget, social security funds, and the operations of central–budgetary institutions and extra budgetary funds. Final data are provided for 1994-96; budgeted data for 1997.
Figure 5.2.
Figure 5.2.

Government Employment in Hungary and Selected OECD Countries, 1995 1

(In percent of total employment)

Source: Organization for Economic Cooperation and Development (1997).1 Producers of government services, except Australia, Austria, Canada, France, Ireland, New Zealand, Spain, and Switzerland, which are general government.
Figure 5.3.
Figure 5.3.

Public Sector Employment in Hungary Compared with Other Central and Eastern European Countries 1

(In percent of total employment)

Source: Schiavo-Campo and others (1997).1 Albania (1996), Bulgaria (1992-94), Croatia (1995), Czech Republic (1994), Macedonia, FYR (1991 and 1992), Poland (1992-94), Romania (1994), Slovak Republic (1994), Slovenia (1994), and Turkey (1991).

The bloated size of public finances and its large deficit reflected underlying weaknesses in several public sector areas, including a complex informational and institutional structure and inefficient and unsustainable pension, health, and subsidy systems.

Informational and Institutional Structure

Fiscal policy management was hampered by inadequate information and complex institutional structures. The central government comprised (and still comprises) four groups of entities: the State Budget (SB), the Central Budgetary Institutions (CBIs) with budgetary autonomy, the Extrabudgetary Funds (EBFs), and the self-governing Social Security Funds (SSFs) (Box 5.1). These entities pursue their institutional objectives and are endowed with their own revenue-raising abilities, within the confines of their instituting laws and the yearly budget law. The CBIs have their own independent revenue sources that, until 1996, were not remitted to a central treasury account, though they were taken into account when measuring the budget deficit.3 The SSFs were, for financial and policy purposes, controlled directly by Parliament, with the Ministry of Finance formally responsible only for commenting on their budgets when these were presented for approval to Parliament. Several transfers and payments took (and still take) place among these entities.4 Partly because of the complexity of intergovernmental flows and the institutional independence of these entities, the compilation of consolidated revenues and expenditure in either an economic or a functional classification has been extremely difficult. This has been an obstacle in fully assessing the economic impact of government policies.

Financial and budgetary rules regulating different levels of government allowed for some slack in financial discipline. For example, there were no controls on, nor systematic accounting of, arrears accumulated by the CBIs. Until 1995, the SSFs had unlimited access to the current account of the State Budget at the National Bank of Hungary. At the same time, the SSFs did not always bear responsibility for their deficits. For example, in 1996, the budget of the Health Insurance Fund (HIF) was prepared under the assumptions of large savings from the closure of hospital beds and new pharmaceutical legislation. None of these measures materialized in time nor bore their budgeted yield. One consequence of the complex institutional structure and of the lack of information systems was that budgets tended to be formulated incrementally, rather than being based on a comprehensive review of expenditure priorities (OECD, 1995a).

The Pension System

The structure of the Hungarian social expenditure system in the early 1990s was essentially intact from the former period, and it was characterized by untargeted social benefits, lax eligibility conditions for old age, survivors, and disability pensions, and generalized access to health care. The job losses generated by the economic transformation were absorbed through a sharp rise in early retirement, particularly disability, and disguised unemployment (Chapter X).5 The result was a social protection system with high access, low benefits, and high social security contributions.

The financial pressures on the pension system have been directly related to the policies prevailing during Hungary’s transition to a market economy, rather than to population aging. The dependency ratio (the ratio of pensioners to workers—36 percent in 1995) has been high and rising during the 1990s due to (1) a reduction in the labor force participation rate (which fell from 85 percent to 76 percent between 1990 and 1994); (2) the increase in registered unemployment (which rose from 0.3 percent in 1990 to about 10 percent in 1995); and (3) an increase in the rate of early retirement, partly due to ad-hoc publicly financed schemes (OECD, 1995b), and of disability pensions (whose number increased by 32 percent between January 1990 and January 1995—Figure 5.4). By 1995, there was almost one disabled person for each 10 healthy Hungarians above age 15. Moreover, contribution revenue declined significantly, from 11 percent of GDP in 1991 to 8.9 percent of GDP in 1995,6 mainly owing to a reduction of the formal sector wage bill relative to total labor income (in turn owing to a shift of workers to self-employment status to minimize overall tax liabilities) and of the labor income share in GDP (in turn owing to falling labor force participation rates and increasing unemployment) (Palacios and Rocha, 1997).

Figure 5.4.
Figure 5.4.

Disability Pensions

Sources: National Health Insurance Fund Administration (various issues); Ministry for Public Welfare, 1996; and data provided by the Ministry of Finance.

Budget Structure

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1 Data refer to end-1994 and June 30, 1997.2 The Central Budgetary Institutions are the decentralized spending units of the ministries. Those with budgetary autonomy have the authority to raise own nontax revenue.3 The two social security funds are the Pension Insurance Fund and the Health Insurance Fund.4 The five extrabudgetary funds operating in 1997 are the Road Fund (managed by the Ministry of Transportation), the Employment Fund (managed by the Ministry of Labor), the National Culture Fund (managed by the Ministry of Education and Culture), the Water Management Fund (managed by the Ministry of Transportation), and the Environment Protection Fund (managed by the Ministry for Environment).

The deficit of the Pension Insurance Fund (PIF) would have skyrocketed under the impact of the above factors had it not been for the fall in the average replacement ratio (ratio of average pension to average wage). This fall was due to three factors: (1) less than full actualization of past contributions; (2) lack of adjustment of the wage brackets in the benefit formula (leading to a reverse bracket creeping effect); and (3) indexation of pensions to the expected net average wage during the upcoming calendar year. As a result, the real value of the average pension declined by 13.1 percent between 1990 and 1994.

The Health Care System

The problems of the Hungarian health system do not relate to the level of public expenditure for health care. Total public health expenditure varied between 6.5 percent of GDP and 7.4 percent of GDP during 1991–94, and then declined to 6.3 percent of GDP in 1996. This level of public health expenditures is not large for Hungary’s level of economic development—as measured by the level of GDP per capita—in comparison with both the OECD countries and other transition economies (Figure 5.5).

Figure 5.5.
Figure 5.5.

Per Capita Public Health Expenditures Versus Per Capita GDP in OECD Countries and Selected Transition Economies 1

Source: Organization for Economic Cooperation and Development (1997a).1 In U.S. dollars, at purchasing power parity.2 Countries include Hungary, Albania, Bulgaria, Croatia, Czech Republic (1993), Poland (1993), Macedonia, FYR (1993), Romania, Slovak Republic, and Slovenia.

The main problems of the Hungarian health care system are its low efficiency, as measured in terms of capacity and input indicators and health outcomes, and the size and unpredictability of the deficit of the HIF. The supply of health care services is characterized by excessive reliance on inpatient care and, in particular, expensive acute care, low ratio of nurses to doctors, and high use of specialist services. This is in large part the legacy of the prereform system, when health sector performance was measured principally in terms of quantitative indicators, such as the number of doctors and hospital beds, rather than performance indicators. In terms of health outcomes, the health status of the Hungarian population, as measured by life expectancy at birth, is by far the lowest among OECD countries and one of the lowest among the central European countries in transition (Figure 5.6). This was not the case before the mid-1970s. The life expectancy of Hungarian males is now two years lower than in 1970–75; the life expectancy of women has increased, but not at the same pace as in other European countries. The main causes of death in Hungary are related to lifestyle (i.e., smoking, alcohol consumption, and dietary habits) (Jozan, 1996), rather than to the level of efficiency of the health care system. However, its lack of effectiveness, and its low ability to adapt to demographic and epidemiological changes, have stimulated public debate.

Figure 5.6.
Figure 5.6.

Life Expectancy Comparisons

Sources: World Bank (1997); Goldstein and others (1997); and Organization for Economic Cooperation and Development (1997a).

The deficits of the HIF have consistently overshot their target—usually set at, or close to, zero percent of GDP (Figure 5.7). As discussed above, the divergence between the approved budget and the outcome is due both to nonimplementation of approved measures and to optimistic assumptions regarding yields from measures. Though the deficit is small in comparison to GDP, it is large when compared to total revenue of the HIF—it has ranged between 5 percent and 9 percent of HIF revenue from 1994 to 1997. The “unpredictability” of the HIF deficit has reinforced concerns regarding the efficient management of health expenditures.

Figure 5.7.
Figure 5.7.

Budgeted and Actual Deficit of the Health Insurance Fund

(In percent of GOP)

Sources: Data provided by the Hungarian Health Insurance Fund; and IMF staff estimates.

Subsidies and Central Budget Social Transfers

A significant portion of the Hungarian consolidated central budget expenditures is devoted to subsidies to (1) different industries; (2) agriculture (including for exports); (3) consumers; and (4) pharmaceuticals. These four types of subsidies accounted for 4½ percent of GDP in 1994.7 The central budget disburses other social transfers, most notably family and child allowances and housing subsidies. These accounted for 4½ percent of GDP and 0.7 percent of GDP, respectively, in 1994. Most subsidies and the social transfers were untargeted and open-ended (actual expenditures at the end of the year were ultimately determined not by the budgetary allocation, but by the number of claimants satisfying the eligibility conditions). Lack of targeting resulted in an inefficient use of public outlays. This was the case for both social expenditures—when the nonpoor receive social transfers and subsidies—and industrial and agricultural subsidies—when the nature of subsidies is such that it actually hinders, rather than promotes, efficient allocation of production and economic transformation. The open-endedness of subsidy and social transfers resulted in unpredictability of public expenditures. Commitments during the year were often higher than budgetary allocations, and would eventually be accommodated in revised budgets.

Smaller Deficit, Smaller Government

In 1995, the Council of Ministers approved a public finance reform program, where it laid out a strategic plan for reforming the role of the public sector in the economy. Its final objective was to achieve a smaller, but more efficient general government, while at the same time strengthening the overall fiscal balance. The plan was structured along four fundamental lines: first, reforming social insurance; second, reducing the tax burden and improving tax administration; third, improving the management of public finances and restructuring public administration; and fourth, reforming intergovernmental finances. All structural changes intervened in the mid-1990s in the area of public finance fit in these four broad categories.

Many of the trends in revenues and expenditures during 1994–97 (which are discussed in the next section) can be interpreted in light of the above strategy. However, these trends are not the result of major structural reforms, but of what could be described as “the silent reform”: several policy measures in different areas that nevertheless considerably furthered the implementation of the overall strategy outlined by the government in 1995. Structural reforms were also approved (mainly old age pensions, health care, and treasury; see below), but their effect will materialize primarily in the medium term.

At the aggregate level, the most apparent results achieved during 1994–97 are the strengthening in the primary balance of the consolidated central government and the dramatic fall in expenditure and revenue ratios. The primary revenue-to-GDP ratio—excluding privatization proceeds—and the primary expenditure-to-GDP ratios dropped, respectively, by 8.3 percentage points and 13.2 percentage points (Figure 5.1).8

As a result, the primary balance improved by 4.8 percentage points of GDP (Table 5.1). About one-half of this improvement was achieved in 1995. In this year alone, the government accomplished 61 percent and 59 percent, respectively, of the total adjustment in primary expenditures and in revenue achieved over 1994–97.9

Table 5.1.

Budget of Consolidated Central Government

article image
Sources: Ministry of Finance; and IMF staff estimates.

Primary revenue is defined as total revenue minus interest revenues and transfer of profits from the National Bank of Hungary.

Primary expenditure is defined as total expenditure minus interest payments and transfers to cover the losses of the National Bank of Hungary.

Part of the decline (about 2 percentage points of GDP) was due to institutional changes, rather than to cuts in underlying public expenditure and revenue. Within the framework of reforming the government role in the economy, 17 CBIs, and networks of CBIs, were transformed into economic associations or nonprofit organizations and left the budget sphere during 1994–97. The removal of these institutions—which continue to perform their public role (mainly supervision and quality control of specific economic sectors, management of state property, and public media)—from the central government definition lowered revenues and expenditure ratios by 1.5 percent of GDP over 1994–97. Moreover, the share of the Personal Income Tax (PIT) accruing to local governments (LGs) was raised, with an offsetting cut in transfers from the central government. This accounts for another drop by 0.3–0.4 percent of GDP in revenues and expenditure ratios. It is also possible that the reorganization of EBFs may have led to a decline in own revenues and expenditures of these institutions, although this effect is more difficult to quantify.

Decline in Primary Expenditures

Primary expenditures were cut in real terms across the board (Table 5.1). The only outlays that remained immune from cutbacks were already at modest levels in 1994: consumer subsidies and central budget investments. The expenditure categories that fell in real terms more than the average reduction in expenses have been those where some structural steps were taken: industrial and agricultural subsidies, transfers to local governments, family allowances and other income supplement benefits, sickness payments, and maternity allowances. However, other outlays (such as wages and disability and old age pensions) also dropped drastically in real terms, reflecting tight budgetary nominal allocations in the presence of high inflation (particularly in 1995). In the remaining part of this section, we will review the main reasons behind the reduction in the above-mentioned expenditure categories.

An important contribution to the decline in the primary deficit over 1994–97 came from the cut by almost 1 percentage point of GDP in agricultural and industrial subsidies, as a result of a tightening in eligibility conditions. Agricultural subsidies had overrun budget estimates by about 30 percent in 1994. The cost overrun was most pronounced for export subsidies, which were volume specific, and therefore, there was no control on outlays. In 1995, the subsidy was specified in terms of export value in dollars. However, reflecting the March 1995 devaluation, this new system also led to higher-than-expected expenditures. To eliminate this problem, since 1996, the per-unit export subsidy has been denominated in forint. In 1997, the list of subsidized products was shortened, the average per-unit subsidy in forint was cut, and product specific ceilings on the exported quantities eligible for subsidies were introduced. The latter measure, together with the imposition of expenditure ceilings and application deadlines on domestic agricultural and industrial subsidies, effectively eliminated the open-endedness character of the explicit subsidies to economic units.

In line with the long-term policy to decentralize the responsibility for financing local services, the central budget has gradually reduced its transfers to LGs, another key component of the adjustment.10 This reduction helped in forcing LGs to cut their expenditure by 3 percent of GDP during 1994–97,11 and to increase their own revenues.12

The third major component of the adjustment in expenditure was the cut in family allowances and other targeted social assistance subsidies, which declined by 2.2 percentage points of GDP to 2.7 percent—a decline of about 45 percent in real terms. This fall was due to two reasons. First—as for other social benefits, including pensions—nominal benefits have not kept pace with inflation. Second, entitlement conditions to family and child allowances have been redesigned to improve targeting. As of April 1996, eligibility to family allowance for the first two children was made conditional on an income test. Other children-related allowances were either eliminated or became conditional to an income test.

Sickness payments were cut by 68 percent in real terms. In 1994, sickness payments had generous replacement rates of 65–75 percent of net earnings and could last up to one year. They were also widely abused. The key policy issue here was the number of days to be paid by the employer, as this affected the incentive for the employer to control abuse. Starting in 1995, employers paid the first 10 days of sick leave, and these were increased to 15 in 1996.

The wage bill of CBIs and SSFs fell by 0.7 percentage points of GDP, reflecting cuts in real wages and employment (which did not affect all sectors equally; Figure 5.8). These cuts were concentrated in 1995 and 1996, and real wages have increased already in 1997.

Figure 5.8.
Figure 5.8.

Real Gross Public Sector Wages

(1994= 100)

Source: Hungarian Central Statistical Office: and IMF staff calculations.

Similar trends arise for pensions expenditure. Real per-capita pensions, which had already declined significantly during 1990–94 (see above), fell by an additional 18 percent during 1995–96. However, already in 1997, average real pensions are projected to have increased by slightly less than 2 percent.

Main Tax Measures, 1994–971

Introduced with the 1995 Budget

  • The VAT base is broadened and rates are increased. Selected pharmaceutical products start being taxed at 12 percent, and the rates on telecommunications and household fuel are changed from 10 percent to 25 percent. The 10 percent rate is changed to 12 percent. With these measures, the average effective tax rate moves closer to 25 percent (the rate at which most goods are taxed).

  • CIT rates are defined differently. The single rate (36 percent) on company profits is replaced by a competitive (18 percent) rate at the corporate level and a supplementary tax of 33.3 percent on distributed profits. With this strategy, the government dismantles in practice most existing preferential tax treatments, although it also introduces an incentive for reinvestment of profits of questionable effectiveness. The withholding tax on dividends is reduced (in November, 1994) from 20 percent to 10 percent. The deductions, allowances, and other incentives previously available to reduce total taxable income are replaced by a tax credit system to broaden the taxable base. During 1995, a ceiling of 81.3 percent of profits is imposed on their distribution of profits. This measure was designed to limit the tax avoidance by the owners of unincorporated businesses.2

  • Several specific excises are increased.

  • Most deductions from the PIT tax bases are transformed into tax credits. The withholding tax on dividends is reduced (in November, 1994) from 20 percent to 10 percent.

Introduced in the March 1995 Package

  • An import surcharge of 8 percent until mid-1997 on all imports with the exception of energy and machinery.

  • Excise tax increases, particularly on cars.

  • Expansion of the contribution base for the health and pension funds.

Introduced with the 1996 Budget

  • A new PIT schedule, including an increase of the top marginal rate from 44 percent to 48 percent, and broadening the base of assessment. A higher tax burden is imposed on persons having income from different sources (e.g., business income) through the application of a different PIT schedule.

  • In CIT, stricter rules are applied regarding the deductibility of expenses and expenses incurred in connection with transactions whose primary purpose is tax avoidance, and new temporary industry-specific and regional tax incentives are introduced. In May 1996, the 1995 restrictions that had abolished, or restricted, incentives for foreign investors were declared unconstitutional with retroactive effect to January 1, 1995.

Introduced with the 1997 Budget

  • The split-rate CIT structure is abolished and replaced by a single tax rate of 18 percent, which is one of the lowest in Europe. The dividend withholding tax is increased to a rate of 20 percent (27 percent on “excess” dividends); interest and royalties paid to nonresidents are subject to withholding tax at 18 percent under a “first pay then reclaim” system. The measures are designed to promote neutrality in competition and to take another step in harmonization with European standards.

  • The PIT dual rate structure is again merged into a single one and the top rate reduced from 48 percent to 42 percent. The withholding tax on dividends is increased from 10 percent to 20 percent, and to 27 percent for “excess” dividends.

1 Additionally, small changes to excise rates, particularly to specific excises, are implemented almost every year.2 These businesses were able to reduce their overall tax liability by taking out most of their income from their business in the form of dividend rather than wages (on which a high marginal PIT schedule and social contribution rates apply).

Decline in Primary Revenue

Most revenue fell in real terms, with the notable exception of VAT, and with relatively stronger declines for security contributions and custom duties (Table 5.1). As discussed above, a driving force behind the revenue decline was the government’s attempt to reduce the tax burden to support growth and improve compliance (see section on tax administration). Unfortunately, many of these measures (which are listed in Box 5.2) also heightened the variability and complexity of tax regulations. The changes to tax policy have been too frequent and sometimes implemented without sufficient consultation. Indeed, some tax measures had to be withdrawn or substantially altered shortly after their introduction.

The decline in social insurance contributions by 2.7 percentage points of GDP is the result of several factors. First, a cut in rates (Table 5.2), which were high by international standards (Figure 5.9) and discouraged compliance (World Bank, 1995; OECD, 1995a). This accounts for a decline in contributions by 1.8 percentage points of GDP. Second, the shift in income distribution: wages and salaries, as a percent of GDP, declined from 36.1 percent in 1994 to 32.7 percent in 1997. Had the wage share in GDP not changed, contributions would have been 1.5 percentage points of GDP higher. These two effects were offset by the broadening of the contribution base (primarily through the inclusion of fringe benefits) and by closing some tax loopholes (most important, those related to income from intellectual income, and business income from nonincorporated partnership).13 Moreover, in 1997, a minimum tax of Ft 1,800 was imposed on all citizens for access to curative health services, and the ceiling on workers’ wage subject contribution payment was increased.

Table 5.2.

Social Insurance Contribution Rates

(In percent)

article image
Sources: Ministry of Finance; and World Bank (1995).

The Solidarity Fund and the Wage Guarantee Fund were merged into the Labor Market Fund in 1996.

Excludes the Rehabilitation Contribution. This is paid by employers, employing more than 20 people, that are not employing disabled workers for at least 5 percent of staff. The contribution in 1997 was Ft 8,000*(5–x), where x is percentage of disabled staff.

Figure 5.9.
Figure 5.9.

Contribution Rates for Social Security Programs in Hungary and Selected OECD Countries 1

Source: U.S. Social Security Administration (1997).1 Includes Old Age, Disability, Death; Sickness and Maternity; Work Injury; Unemployment; and Family Allowances. In some countries, the rate may not cover all of these programs. In some cases, only certain groups, such as wage earners, are represented.2 The central government pays the whole cost of Family Allowances.3 3Plus flat amount for disability (see Table 5.3).4 Plus flat amount for Work Injury.5 Plus flat amount for Unemployment.6 Range according to earnings bracket. Higher rate is shown, which applies to highest earnings class.7 The central government pays the entire cost of most programs from general revenues.

The sharp fall in customs revenues was almost entirely driven by tariff reductions due to the Hungarian government commitments to the Association Agreement with the European Union and to the World Trade Organization (WTO). During 1994–97, the effective rate of custom duty—the ratio of duty revenue, including statistical fees, to dutiable imports—declined from 9½ percent to about 3½ percent. This cut was initially offset by the import surcharge (see above and Chapter IX), which was gradually reduced and fully eliminated at mid-1997.

Other revenue items posting large reductions are from the own revenue of the CBIs and of the EBFs (Table 5.1). As discussed above, three-fourths of the fall in CBIs’ own revenue is due to the removal of some CBIs from the budgetary sphere. The decline in EBFs’ own revenue may, at least in part, reflect the reorganization of the sector and the elimination of financial flows with other branches of the general government. The EBFs had independent revenue sources, including from commercial activities, and independent spending authority. Between 1995 and 1997, the government wound down most funds by merging some of them or by absorbing them in the ministries from which they depended. As a result, the number of EBFs fell from 32 to 5 (Box 5.1). Moreover, their budgetary independence has been curtailed, and they were brought into the treasury system in 1996, with positive effects on cash management for the consolidated central government (see below).

More than one-half of the fall in PIT revenue is due to the above-mentioned increase of the PIT share going to the LGs. However, other factors have been at play (Table 5.3). First, in 1995, the fall in real wages reduced the tax base by 3.4 percentage points of GDP. Second, bracket creeping had an enhancing effect on PIT revenue, as the effective tax rate increased by 9.4 percentage points of the tax base between 1994 and 1997—notwithstanding the reduction in the rate schedule implemented in 1997. Third, the importance of tax credits has continuously increased, as they now reduce retained revenue by 2.5 percentage points of GDP. As a result of these offsetting forces, the net effective tax rate has been remarkably stable during 1994–97.

Table 5.3.

PIT Indicators

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Sources: Ministry of Finance; and IMF staff estimates.

Ratio of PIT collections (on progressive schedule only) to net progressive tax base.

Ratio of PIT collections (on progressive schedule only) minus tax credits to net progressive tax base.

As to other taxes, the decline in excises is mainly due to the fact that consumption—which is closely related to excise taxation—has declined from 85 percent of GDP to 76 percent of GDP during 1994–97 (the ratio of excise revenue to consumption has remained broadly stable over the period). Corporate Income Tax (CIT) revenue has decreased only marginally, despite an increase in the taxable profits by 3.8 percentage points of GDP over 1994–95. This fall in revenue is due to the halving of the CIT rate from 36 percent in 1994 to 18 percent in 1997. The increase in VAT revenue is due mainly to base broadening and the elimination of exemptions implemented in 1995 and to administrative improvements, which were particularly relevant in 1997 (see next section).

Structural Reforms

Structural reforms have been implemented in four main areas: (1) the institutional structure; (2) the pension system; (3) the health care system; and (4) tax and customs administration.

Institutional Structure

Important structural changes were implemented in this area. The treasury started operating on January 1, 1996. All cash money from central government agencies and institutions started passing through a single treasury account held at the National Bank of Hungary, thus replacing a multitude of previously existing accounts. This allowed the central government to keep track of, and optimize the use of, cash balances held by its entities. The treasury was also assigned the supervision of the disbursement of subsidies to enterprises and of transfers to other entities of the general government. This allowed the implementation of a system of net financing for LGs: the treasury started transferring the LGs’ PIT share after netting it out of social security contributions due by LGs to SSFs and EBFs. The same has occurred for subsidies to enterprises: the treasury does not effect any transfer to organizations that have social security or tax arrears. These changes have improved collection rates for social security and tax revenue. In April 1996, the Center for Government Debt Management also came under the authority of the treasury. In January 1997, also the accounts of the SSFs were brought into the treasury system. At the same time, the treasury started recording commitments against budgetary appropriations and payments for CBIs’ expenditures regulated by the new Public Procurement Law, thus allowing a better monitoring of arrears. The Public Procurement Law itself introduced transparency and major economies in purchases by both the central and local governments.

The establishment of the treasury has made available real-time information on the cash and debt position, expenditure disbursed, and revenue collected of all entities of the consolidated central government. However, this centralization of accounts was not accompanied by changes in budgetary codes and by a new chart of accounts. Therefore, it remains difficult to classify government operations according to full economic and functional lines.

New budgeting, accounting, and reporting rules were introduced for the SSFs in 1996. The SSF budgets are now formulated within the time frame of the overall government budget. These changes have eliminated the possibility of delays in approving the budgets of the SSFs, which were all too common in the past. The SSFs are now also required to present quarterly budgetary reports to Parliament and to the government, and to prepare long-term projections of their revenue and expenditures. Since December 1996, the General Assembly of the SSFs has lost its veto power on government decrees related to social insurance. Finally, a new institutional law was adopted by Parliament in June 1997, reforming the procedures of nomination of members to the General Assembly of the Self-Governments.

Pension Reform

The pension reform has been approved in two parts. First, in 1996, the existing pay-as-you-go (PAYG) system was reformed. Second, in 1997, a new multipillar pension system, including a fully funded component, was established for implementation in January 1998. Hungary is the first country in Eastern Europe to adopt a multipillar pension system, and the second country in Europe (after the United Kingdom) to make a switch to a multipillar system.

The most significant changes to the existing PAYG were (1) a gradual increase in retirement age (combined with a rise in the minimum years of service for early retirement); (2) the shift from wage indexation of pensions to a combination of wages and prices with equal weights; (3) the introduction of a new benefit formula; (4) tighter eligibility criteria; (5) changes in the rules regarding survivors’ benefits; and (6) changes in the tax treatment of pension benefits and contributions (Box 5.3). The first two measures have the strongest positive impact on the finances of the system. The other measures have a lesser fiscal impact, but have important implications for the incentives to comply and for income distribution.

The multipillar system comprises a new and downsized first pillar—publicly managed and financed on a PAYG basis—and a new second pillar—privately managed and fully funded. A voluntary third pillar (also privately managed and fully funded) has been in operation since early 1994.14 The new system will be mandatory for all new entrants into the labor force as of July 1, 1998. Workers who have entered the labor market before July 1998 will have the option of staying in the reformed PAYG or to switch to the new system. Workers staying in the reformed PAYG could expect an entry pension, before taxes, of 60–65 percent of the average wage. Workers under 35–40 years of age are likely to find it attractive to shift to the new system, as below this age, the expected return on the second pillar accounts will outweigh the partial loss of benefits accrued under the old system, leading to an entry level pension of 65–72 percent of the average wage.

The flow of resources to the second pillar and, therefore, its impact on the deficit of the PIF would average 1 percent of GDP in the first years of implementation.15 After 10 years of implementation, the assets accumulated in second pillar accounts could amount to approximately 15 percent of GDP.16 There is a guarantee on minimum second pillar replacement rate defined as 25 percent of the replacement rate that the worker would receive from the first pillar. This guarantee effectively establishes a contingent liability for the new pension system, which has not been quantified yet. This liability is backed by resources of the Guarantee Fund. Mostly older workers, who have a shorter period of service, are likely to benefit from this guarantee. Therefore, the government expects this guarantee not to be large.17

Reform of the PAYG and New First Pillar

Retirement Age Increase

The statutory retirement age will gradually reach age 62 by the year 2009. Until that year, workers have the option of retiring as early as age 57 without penalty if they have completed the required number of statutory years of participation in the system. Retirement with fewer years of service is also possible but with a penalty. After 2009, the earliest a person can retire is age 59 if the worker has completed 37 years of service. Those who have accumulated 40 years of service can retire between ages 59 and 62 without any penalty. The changes in retirement age regulations are expected to lead to an increase in the effective retirement age of approximately 5–6 years for women and 2–2½ years for men by the year 2010.

Indexation Rules

The change in indexation involves a gradual shift from annual net wage indexation to an evenly weighted average to wages and prices. The net wage indexation will be maintained in 1998 and 1999 to allow a partial compensation for the decline in real pensions in 1995 and 1996, the years when real pensions declined significantly. In 2000, the government will start delinking pensions from wages, applying a mixed formula of 30 percent price and 70 percent net wage indexation. The 50/50 indexation formula will be fully implemented in 2000. Under the assumption that GDP and real wage growth will average 3–4 percent a year in the next decade, the reforms would lead the PAYG generating surpluses of more than 1.5 percent of GDP during that period—before the losses associated with the introduction of the second pillar are taken into account.

Benefit Formula

The new benefit formula applies a set of lower coefficients to a worker’s gross wage history. The new formula will be used for the calculation of new pensions after 2012, and will replace the current schedule of higher coefficients that are applied to a worker’s net wages.

Eligibility Criteria

The number of noncontributory years counted toward retirement for students and women on maternity leave will be reduced.

Rules on Survivor Benefits

Starting in 1998, survivor pensions will be awarded regardless of other pension income. This change is applied retroactively and is estimated to add approximately 20 percent to the average survivor pension. However, since survivor benefits are low and account for a small share of pension expenditures, the increase in pension outlays generated by this change is expected to account for about 0.1 percent of GDP.

Taxation Treatment of Contributions and Benefits

The changes in the tax treatment include the introduction of a 25 percent tax credit on mandatory employee contributions (to the PAYG and the second pillar), exempting investment income in the second pillar and taxing pension benefits. Although the changes in the tax treatment imply a loss of revenues of the personal income tax of approximately 0.5 percent of GDP in the first stages of the reform, they move Hungary much closer to the tax treatment applied in most OECD countries, which involves exempting contributions and investment income while taxing benefits.

The pension reform represents a key step forward in consolidating public finances in Hungary. The reform of the PAYG system goes a long way to reverse the otherwise inevitable deterioration of pension accounts in the long term.18 Moreover, the introduction of a fully funded component is important in encouraging compliance and in developing the capital market. Other steps are expected to follow soon. A key issue that still needs to be addressed is disability pension reform. Although a parliamentary resolution adopted in July 1997 outlines its main principle and sets 1999 as the date for its implementation, much preparatory work needs to be done to meet this target.19

Health Reform

It is misleading to say that the government implemented a full-fledged health reform in 1994–97. From the early 1990s, the government had already implemented a myriad of changes to the financing, delivery, and institutional structure of the health care system and it has continued to do so. Although over the past two years the legislative effort in this area has intensified, measures taken have fallen short of a fully fledged reform.

During the first half of the 1990s, Hungary moved from a centrally planned public health care system, financed through general budget revenues, to a delegated and decentralized system, financed through a combination of social insurance payments (to cover part of the outlays of the HIF), general budgetary revenue (for the outlays of the state and LGs), and patients’ outlays for drugs and private medicine (Box 5.4). However, as discussed above, there are still numerous concerns regarding the efficiency of the system and its deficits.

In 1995, the government added to its legislative agenda the improvement of the efficiency of health care delivery and the reduction of its fiscal burden. This led to the approval of the Act on Capacity Reduction in July 1996,20 the Act on Health Insurance in July 1997,21 and the Act on Social Insurance Eligibility and Financing, regulating the revenue of both the PIF and HIF, also in July 1997. Moreover, the government presented to Parliament a draft of the Health Care Act, regulating the organization of the health sector.

A full discussion of these measures is included in Ruggiero (1997). Here, it is enough to note that the approved laws represent a useful streamlining of existing regulations and contain some useful measures. However, they fall short of introducing those economic incentives to efficiency that in the medium to long term will be necessary to improve the overall effectiveness and viability of the health system.22 Moreover, in some cases (such as the Health Care Act), the new legislation provides a framework—outlining the basic principles regarding the role of the government, the rights and responsibilities of individuals, the agents/units included in the health delivery system, and the professional requirements for supplying health services—and will need to be followed up by implementing legislation.

Tax and Customs Administration Reform

Weak tax compliance has been a key fiscal problem in Hungary during the 1990s. Some Hungarian studies (Arvay and Vertes, 1995) suggest that the gray economy is as large as 30 percent of economic activity, and this is both the cause and the effect of high statutory marginal tax rates. Indeed, all tax revenue as a share of reported income are well below the levels that should be generated by the official tax rates (OECD, 1997c). Part of the erosion of the tax base has come from the movement of economic activity from large easy-to-tax state firms to small businesses, whose accounts are hard to monitor, and whose income is therefore hard to tax (OECD, 1995a). But, as discussed below, this erosion is also due to disincentives implicit in the tax system. Many of the tax policy measures of the mid-1990s were designed with the objective to improve tax collection through better compliance.

In addition, there was a significant effort to improve tax administration and adapt it to the new forms of economic organization. Until 1995, manpower in the tax authority (Ado es Penzugyi Ellenorzesi Hivatal (APEH)) had not yet increased, the percentage of staff working on auditing was relatively small, training was mostly on the job, and there was no structured national audit strategy. In 1996, increased financial resources were allocated to APEH, and staff was increased by 8 percent. A Large Taxpayer Unit was established in January 1996. Though its activity was limited in its first year of implementation to about 300 taxpayers in Budapest (350 in 1997), these represent 55–60 percent of the revenue collected in the capital—and Budapest produces about 70 percent of the Hungarian tax revenue. In 1997, APEH was allowed to increase its staff by an additional 20 percent, which was allocated primarily to audit and collection functions. Also, in January 1997, a national audit plan was approved, which attempted to shift the focus of audits toward medium-sized firms.

A Chronology of Reform Measures in Health Care

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Two other administrative measures were implemented to improve collection of tax arrears. First, in early 1996, APEH was given the power to send a notification of seizure of asset to delinquent enterprises; failing that, APEH can now actually seize both tangible and intangible assets. Second, as of the second half of 1996, enterprises entitled to receive any payment from the central budget, including subsidies, first have to clear any outstanding tax liability with APEH and the SSFs. Similar seizing powers were also bestowed upon the Customs Administration (VPOP), which also considerably increased its staff in 1997 (by 14 percent).

Considerable progress has been achieved in improving tax administration, although further progress is possible.23 In this respect, compliance and effectiveness of tax administration would be considerably helped by a simple, transparent, and stable tax environment. In a closely related area, efforts to integrate the collection and auditing of social security contributions (managed by the HIF and the PIF, respectively) and the general tax collection may generate efficiency savings by eliminating unnecessary duplications (and excessive burden on taxpayers), and should improve the capacity of authorities to detect tax evasion.

References

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  • Goldstein, Ellen, and others, 1996, “Trends in Health Status, Services, and Finance,” World Bank Technical Paper No. 341 (Washington: World Bank).

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  • International Monetary Fund, 1996, Government Finance Statistics Yearbook (Washington: International Monetary Fund).

  • Józan, Péter E., 1996, “Health Crisis in a Society in Transition: The Hungarian Case” (mimeographed).

  • Ministry for Public Welfare, 1996, Yearbook 1995 (Budapest).

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  • Organization for Economic Cooperation and Development, Centre for Cooperation with the Economies in Transition, 1995b, Social and Labour Market Policies in Hungary (Paris: OECD).

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  • Palacios, Robert, and Roberto Rocha, 1997, “The Hungarian Pension System in Transition” (unpublished, World Bank, July).

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  • Schiavo-Campo, Salvatore, Giulio de Tommaso, and Amitabha Mukherjee, 1997, “An International Statistical Survey of Government Employment and Wages,” Policy Research Working Paper No. 1806 (Washington: World Bank).

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1

The focus is on the consolidated central government as defined in Box 5.1. This definition is narrower than the definition of public sector used in Chapter II, which covered local governments, the state privatization agency (APV Rt), and the central bank.

2

The average expenditure figure is based on the 22 OECD countries for which 1994 consolidated central government data from International Monetary Fund (1996) are available.

3

Until 1995, the CBIs were allowed to purchase government securities and treat the interest revenue as their own resources.

4

For example, the Central Budget makes transfers to the Extra-budgetary Funds for nationally relevant investments, pays social insurance contributions on the salaries of its employees to the SSFs and the EBFs, and transfers figurative amounts to the SSFs for coverage of the population exempt from social insurance contributions; the Labor Market Fund (an EBF) pays social security contributions to the Pension Fund (an SSF) for the unemployment benefits that it disburses; the Health Fund (the other SSF) transfers funds to the CBIs and to local governments for financing the hospitals that are owned by the latter. There are also internal transfers and payments among EBFs, SSFs, and CBIs.

5

In 1994, about 600,000 unemployed, though statistically counted as employed, were sheltered in various long-term leave and work/training programs (World Bank, 1995).

6

These are the contributions revenue to finance old age, survivors, and disability pensions. Contribution revenue for the two SSFs together declined from 16.9 percent of GDP in 1990 to 13.3 percent of GDP in 1995. The decline in 1995 is also due to the wage policies of the March stabilization package, as real average wages fell by more than 10 percent in that year.

7

These are the explicit subsidies in the budget only. In fact, other expenditure categories (i.e., investments) include outlays that should instead be classified as subsidies (i.e., transfers to households to reduce the interest costs of housing loans).

8

In this chapter, all revenues and expenditure ratios for 1997 refer to the 1997 budget, as a detailed breakdown of actual revenues and expenditures is not yet available.

9

The 1995 adjustment reflected primarily the package approved in March 1995, the so-called Bokros package, named after the Minister of Finance who put it forward. The main elements of this package were, on the revenue side: the imposition of a temporary 8 percent import surcharge (with the exception of energy and machinery imports); excise tax increases, particularly on cars; and an expansion of the social security contribution base. Revenues were also aided by higher inflation and devaluation (Chapter II). On the expenditure side, the package included: (1) a cut in wage allocations to CBIs by a further 3 percent; (2) a freeze of current purchases in nominal terms; and (3) amendments to public sector employment laws so as to facilitate employment cuts. The proposed replacement of universal family and child allowances with targeted social assistance was cancelled by the Constitutional Court—and approved in 1996, in a different form.

10

After the establishment of a two-tier system of government in 1990–91, the delivery of education, health, and social welfare services was devolved to LGs with the objective of making the provision of these services more responsive to local demand, and strengthening accountability of local administrators. As noted above, a small part of the reduction in transfers was offset by a larger allocation to LGs of PIT revenues. The PIT transferred to the LGs is assigned partly on a derivation basis (to the same municipality on whose territory it is collected) and partly on an equalization basis (to poorer municipalities). The latter portion has increased over the last few years, and it will continue to do so until the year 2000, when it will reach 20 percent of the PIT collection—out of a total of 40 percent transferred to LGs.

11

Employment in LGs was reduced by 7 percent to about 533,000 people in 1997.

12

The percentage of own current revenue in total revenue increased by 2.8 percentage points to about 20 percent. Shared revenue increased by 5 percent to about 14 percent, and transfers decreased by 6.5 percent to about 36 percent.

13

There are no social security contributions payable on business income from nonincorporated partnerships. Therefore, to avoid paying high social security contributions, entrepreneurs fired workers and rehired them on contracts. These workers would then set up partnerships from which they would receive substantial revenue in forms of dividends. As a result, there were about 100,000 nonincorporated partnerships in 1996. These tax regulations not only erode the base of the social security contribution, but also reduced PIT revenue. In 1997, to alleviate this problem, a higher rate on the PIT withholding tax on capital income was imposed on the distribution of “excess” dividends.

14

By mid-1997, the number of contributors to the third pillar had reached 575,000, or roughly 15 percent of the labor force.

15

An additional fiscal cost of the transition is a new PIT credit of 25 percent of employee contribution to the first and second pillar. The impact of this credit on PIT revenue is likely to be about 0.5 percent of GDP

16

The private pension funds managing these assets would be legally structured along the lines of the private pension funds already operating since early 1994, called voluntary mutual benefit funds. However, the regulatory framework for the second pillar will be stricter than the framework currently guiding the voluntary third pillar. In particular, pension funds operating in the second pillar will be subject to a minimum size, contribute to a central Guarantee Fund, hire custodian services, submit quarterly reports to the supervision agency, subject to some investment guidelines, and subject to stricter professional requirements for asset management.

17

The guarantee creates two additional problems. First, more people may decide to switch to the new system and, therefore, the costs of the transition may be higher. Second, the individual-specific guarantee may add to administrative costs, especially if the guarantee is frequently monitored by actuaries.

18

The PAYG system is expected to remain in surplus for the next 30–35 years. Later, a deficit is expected to emerge, reflecting demographic trends.

19

In the new system, vocational criteria—together with the current medical ones—will be used to determine eligibility as well as the degree of disability. Instead of focusing on the worker’s lost ability to work, the new system will emphasize the worker’s remaining ability to work. Permanent benefits will be awarded only to the most serious medical cases. The reform will require strengthening the medical examination network, establishing rehabilitation centers, and reforming the Labor Market Fund and the social assistance programs. Once the new system is in place, the government should be able to start a recertification program for those who are currently classified as temporarily disabled—whose ranks are reputed to include many long-term unemployed (Chapter X).

20

The Act on Capacity Reduction aims at reducing excess capacity in the hospital system, excessive and inappropriate hospitalization rates, and excessive length of stay. It defines inpatient and outpatient capacity by county and for each medical specialty until 2000, when it is hoped that the formula would provide a ratio of 80–85 hospital beds per 10,000 inhabitants.

21

The Act on Health Insurance aims at increasing the efficiency of the health system, mainly by diverting excess demand for secondary health care services toward preventive and primary care. The main points of the act are the following. First, the act classifies health treatments into three broad categories, according to the degree of patients’ participation in the cost of services: (1) treatments not covered by insurance (e.g., several types of transplants, sterilization, and acupuncture); (2) treatments provided free of charge (e.g., screening, preventive, and curative services); and (3) specific situations when the institution delivering the service is authorized to collect copayments. Second, the act specifies treatment guidelines that regulate access to services. These include the requirement of a written referral for most out/inpatient treatments and the physicians’ obligation to refer patients to the lowest possible level of care. Third, the act redefines the HIF’s contracting procedures with, and its supervision over, the health institutions and the physicians.

22

For example, the reform contains little incentives for health institutions to charge copayments. Therefore, it is unlikely that these will be increased to control excess demand. The law also fails to assign the HIF a broader autonomy to contract with providers for the level and composition of services it deems necessary. Therefore, a competitive market between suppliers of health care services has yet to be established.

23

A tax administration modernization project, focusing on an ambitious computerization program, is supported by the World Bank.

Within Same Series

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Cover Hungary
Hungary
Economic Policies for Sustainable Growth
Author: International Monetary Fund
ISBN:
9781557757098
ISSN:
0251-6365
Publication Date:
12 Feb 1998
Publisher:
International Monetary Fund
DOI:
https://doi.org/10.5089/9781557757098.084
Pages:
108
  • View in gallery

    Consolidated Central Government Primary Balance 1

    (In percent of GDP)

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    Government Employment in Hungary and Selected OECD Countries, 1995 1

    (In percent of total employment)

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    Public Sector Employment in Hungary Compared with Other Central and Eastern European Countries 1

    (In percent of total employment)

  • View in gallery

    Disability Pensions

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    Per Capita Public Health Expenditures Versus Per Capita GDP in OECD Countries and Selected Transition Economies 1

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    Life Expectancy Comparisons

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    Budgeted and Actual Deficit of the Health Insurance Fund

    (In percent of GOP)

  • View in gallery

    Real Gross Public Sector Wages

    (1994= 100)

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    Contribution Rates for Social Security Programs in Hungary and Selected OECD Countries 1

Consolidated Central Government Primary Balance 1

(In percent of GDP)

Government Employment in Hungary and Selected OECD Countries, 1995 1

(In percent of total employment)

Public Sector Employment in Hungary Compared with Other Central and Eastern European Countries 1

(In percent of total employment)

Disability Pensions

Per Capita Public Health Expenditures Versus Per Capita GDP in OECD Countries and Selected Transition Economies 1

Life Expectancy Comparisons

Budgeted and Actual Deficit of the Health Insurance Fund

(In percent of GOP)

Real Gross Public Sector Wages

(1994= 100)

Contribution Rates for Social Security Programs in Hungary and Selected OECD Countries 1