Selected Issues and Statistical Appendix

The Hungarian government implemented significant restraint and reforms in the mid-1990s, but substantial challenges remain in the medium term. Medium-term fiscal framework will assist in evaluating the preferred approach to managing this range of expenditure pressures and structural reform issues. The paper presents scenarios illustrating the tensions in fiscal policy, and the potential role for medium-term expenditure restraint to achieve fiscal objectives while facilitating growth. The statistical data on the economic indices of Hungary are also presented in the paper.


The Hungarian government implemented significant restraint and reforms in the mid-1990s, but substantial challenges remain in the medium term. Medium-term fiscal framework will assist in evaluating the preferred approach to managing this range of expenditure pressures and structural reform issues. The paper presents scenarios illustrating the tensions in fiscal policy, and the potential role for medium-term expenditure restraint to achieve fiscal objectives while facilitating growth. The statistical data on the economic indices of Hungary are also presented in the paper.

Managing Medium-Term Fiscal Challenges in Hungary

I. Introduction

1. Hungary has largely completed the transition process and has shifted focus to the challenges of EU accession. Structural reforms of the real and financial sectors have laid the foundation for rising investment, high FDI inflows, and strong growth, with real GDP growth averaging 4½ percent in 1997–99. Privatization revenues were used to substantially reduce foreign debt from high levels in the early 1990s. Fiscal consolidation in 1995–96 drove a turnaround from the excessive external current account deficits of 1993–94, and also facilitated a reduction in CPI inflation from rates persistently above 20 percent through 1992–94, to 10 percent on average in 1999.1 The implicit debt arising from demographic pressures has been addressed by pension reform, though the health system remains exposed to these pressures. Altogether, the quasifiscal issues facing transition economies have been effectively tackled, in a manner that has contained contingent liabilities (Brixi et al, 1999).

2. EU accession and other factors will exert pressures on public expenditures in the medium-term, creating a tension in fiscal policy given constraints on revenues and the fiscal stance. Accession to the EU is associated with spending for legal approximation and institution building, development of the transport infrastructure, and compliance with environmental standards. Rising healthcare costs are expected in the medium and longer terms. However, revenues cannot be increased to accommodate expenditure pressures because the Hungarian authorities aim to reduce tax and social security contribution rates from high levels to promote employment, which is low by OECD standards.2 3 The authorities also seek to maintain a sustainable external current account deficit, implying no room to relax the fiscal stance considering the anticipated robust growth in private investment.

3. This paper seeks to illustrate the nature and magnitude of these tensions in fiscal policy, and to explore policy goals and frameworks that might help resolve these while supporting growth. Given the various expenditure pressures and losses in customs revenues, there is a tension between achieving a modest fiscal consolidation while also easing the high labor tax burden. This tension could be addressed through reforms to improve the efficiency of public services—often provided by local government-and also the effectiveness of household transfers, with the broad goal of freezing these expenditures in real terms. The resulting savings would facilitate tax reform, healthcare reform, and higher public investment, together supporting higher growth. To help promote such fiscal reforms and consolidation, a number of other OECD countries have used medium-term budget frameworks, and lessons from this experience may help guide the further development of this type of framework in Hungary.

4. The paper is organized as follows. Section II outlines the medium-term expenditure demands facing the Hungarian government, also noting areas where reforms may improve services or reduce costs. Key issues in designing a medium-term fiscal framework are discussed in Section III, including private savings and investment prospects and the role of fiscal policy in growth. A quantitative illustration of fiscal strategies in the context of EU accession is then presented in Section IV. The baseline scenario illustrates the tensions in fiscal policy, while the reform scenario aims to realize the authorities’ fiscal objectives in a growth supporting manner. Implementation of a medium-term fiscal strategy is complex in practice, and Section V considers lessons from OECD country experiences in this area, as well as possible applications in Hungary.

II. Public Expenditure Issues and Outlook

5. The Hungarian government implemented significant restraint and reforms in the mid–1990s, but substantial challenges remain in the medium-term. Primary expenditures of general government were cut from some 50 percent of GDP in 1993 to 39 percent of GDP in 1998, as discussed in Ruggiero (1998).4 While much reduced, government expenditure remains somewhat high for Hungary’s level of development (Figure 1) and this can only be partly accounted for by demographic and other factors.5 The following seeks to identify the main medium-term expenditure challenges, and also some of those areas recognized to be likely to benefit from reform. The discussion is based on recently developed official data classifying expenditures by function (Table 1). The impacts of EU accession on the budget are discussed throughout, and are summarized in Box 1 and Table 2.

Figure 1.
Figure 1.

Hungary: Government Size and Income Level in EU Countries, 1960-97 1/

(Five Year Averages)

Citation: IMF Staff Country Reports 2000, 059; 10.5089/9781451817850.002.A001

Source: OECD, Economic Outlook.1/ Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Netherlands, Portugal, Spain, Sweden and UK.
Table 1.

Hungary: General Government by Function, 1997-99

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Source: Ministry of Finance.
Table 2.

Hungary: EU Related Spending and Financing

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Sources: Hungarian Authorities--National Programme for the Adoption of the Acquis.

EU assistance under Phare, ISPA, SAPARD.

Local governments, NGOs, private sector.

Direct Fiscal Impact of EU Accession

Direct fiscal impacts of EU accession include the EU related transfers, changes in revenue due to tax and customs policy compliance with EU standards, and expenditures required to meet EU standards. There is a range of potential outcomes for each depending on the negotiated accession agreement and internal EU reforms.

Expenditures: Hungary’s National Program for the Adoption of the Acquis (NPAA) envisages that by end 2001, Ft 824 billion will be spent on legal and institutional development and economic development, (Table 2), a cumulative 6½ percent of GDP. Of this, some 3 percent of GDP is financed by central budget, but up to 4½ percent of GDP is financed by general government. Employment of some 10,000 central administration staff to execute these tasks is also envisaged. Over the longer run, complying with EU environmental standards, and road and railway development costs, will require significant investments, that may be spread over 10–20 years. Expenditure on agriculture will also increase after accession, because a part of EU transfers will be dedicated to agricultural support under the revised Common Agricultural Policy.

Transfers: The NPAA envisages transfers from the EU rising from 0.2 percent of GDP in 1999 to some ¾ percent of GDP in 2000–01, making a significant contribution to covering accession costs. Indeed, the contribution of the central budget would only rise by ½ percentage point of GDP from 0.7 percent of GDP in 1999 to 1.2 percent in 2001. It is unclear how much of the funding from sources other than the central budget and the EU would be required from local governments as opposed to NGOs and the private sector, but it seems likely that the majority will be from local governments. In this case, the rise in spending required by EU accession at the level of general government would be in the order of 1 to 1½ percent of GDP. After accession, it has been estimated that Hungary would pay about 400–500 million euro, but receive about 2.5-3.1 billion euro per annum—from the Common Agricultural Policy, Structural Fund, and Cohesion Fund—giving a net potential inflow of 2-2.7 billion, or 4½ to 6¼ percent of current GDP. These estimates appear to be consistent with the limits agreed at the Berlin European Council in March 1999.

Revenue effects: As tariffs are cut on accession to the common EU trade policy, customs revenues are expected to shrink from 1¼ percent of GDP at present to an estimated ¼ percent, though there will be some prior decline to about ½ percent of GDP as Hungary meets its WTO commitments. Other countries, e.g. Poland, must lift excise taxes on alcohol, cigarettes, and fuels to meet EU standards, but this does not appear to be the case in Hungary.

A. Public Services

6. Earlier reforms have reduced the resources used by the government, but efficiency can still be improved in the core public services. Employment in general government has fallen from 870 thousand in 1995 to 809 thousand in 1997, but has since rebuilt to 816 thousand in 1999 (Table 3). Coupled with real wage restraint, the public sector wage bill has fallen from 8.1 to 7.2 percent of GDP from 1995 to 1999. Public sector consumption has fallen from 11.0 percent of GDP to an estimated 10.6 percent in the same period, so the total resource savings have been some 1¼ percent of GDP. Nevertheless, the share of public employment remains at the high end of the OECD (Figure 2) partly reflecting the large number of local governments which each provide core public services (Box 2). The following outlines the situation in healthcare, education, and defense.

Table 3.

Hungary: Public Employment and Wages

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Source: Ministry of Finance, and staff estimates.
Figure 2.
Figure 2.

Hungary: General Government Employment and Compensation

Citation: IMF Staff Country Reports 2000, 059; 10.5089/9781451817850.002.A001

source: OECD1/ Compensation costs include social security contributions, except for Australia, Canada and the United states.

7. Healthcare expenditure is not high for Hungary’s level of economic development, but efficiency in health care delivery is low, contributing to poor health status. Health care expenditure by the budget was 4.6 percent of GDP in 1998, typical for Hungary’s per capita income level, but the health status of the population appears to be the worst in the OECD, see OECD (1999). Underlying problems are reflected in the high ratio of doctors to nurses and substantial overcapacity in hospitals. Local government management of hospitals faces limited incentives to contain costs because 90 percent of expenditures are financed by transfers from the Health Insurance Fund, which does not act as a selective purchaser. Reform of the healthcare system has been identified as a priority by the EU in the 1999 Regular Report.

8. There are pressures for healthcare costs to rise sharply in coming years, but reforms could moderate this increase significantly. Rising healthcare costs—by at least 1½ percent of GDP in the next decade—are expected in the absence of reforms, with additional pressures from population aging after 2010 (World Bank, 1999). The World Bank urges a gradual reform of the health system, to strengthen financial discipline and orient spending towards services with greatest health benefits. Reforms would initially require a ½ percent of GDP rise in expenditures, mainly for repairs and modernization. Public spending would then stabilize in the remainder of the decade, though private expenditure would increase, because services outside a defined benefit package would be financed through private insurance. While health system reform is not expected to generate fiscal savings in the medium-term, there is potential for savings on pharmaceutical subsidies (1¼ percent of GDP in 1999) where public funds are lost on medicines resold on the black market.

9. Education reform could simultaneously address overstaffing and low wages. With 4¾ percent of GDP in total education spending, per student spending relative to per capita GDP is a little above the international average (Aradi et al., 1998). However, Herczog et al (1998) find substantial overstaffing, and student-teacher ratios are very low, with 1996 ratios of 12.2, 10.4, and 9.9 in primary, secondary, and university level education respectively, compared with OECD averages of 17.9, 14.5, and 17.1 (Clements, 1999). Staffing has not matched the decline in pupil numbers, with a further decline projected for coming years.

Structure of the General Government

From a unitary government prior to 1990, the Hungarian public sector, and therefore control over public spending, has become quite decentralized.1 Central government has 34 budget chapters, under which there are 1,294 central budgetary institutions (CBI). The pension fund (PIF) and health fund (HIF), provide pensions (old-age, survivors, and disability) and healthcare and related benefits respectively. The two extrabudgetary funds (EBF) are the Labor Market Fund providing unemployment insurance and related services, and the Central Nuclear Fund—where the number of such funds has been cut from 29 in 1995. Local government (LG) is responsible for delivery of utilities, education, health and other services, and it employs some 65 percent of the 816 thousand public sector workers. The municipal sector is very fragmented, with 3170 municipal bodies as of 1997—serving on average 3250 citizens—with 13422 local budgetary institutions (LBI), including schools, hospitals, universities, and other service providers.

Though many levels of government have their own revenue sources, the central government has significant leverage via transfers. Institutions with budgetary autonomy—about half of CBIs and some 60 percent of LBIs—can use higher-than-expected revenues to fund higher than budgeted expenditures. In 1998, CBIs spent 10.8 percent of GDP, of which their own revenues covered 31 percent, with the majority of funding being central transfers. Local governments received current revenues of 12 percent of GDP in 1998, of which 15 percent were tax shares, and 52 percent were transfers from other levels of government, with just 33 percent of own revenues.

A variety of mechanisms exist to ensure budgetary discipline despite the number of autonomous budgetary institutions. A centralized Treasury was established in 1996, bringing central government funds (including SSFs and the own revenues of CBIs) through a single account, Thuma et al (1998). Cash disbursement controls are in place, for example, Treasury disbursements to LGs are made net of the LG contributions due to SSFs and EBFs. Local government debt (borrowing, bond issues, and guarantees) is limited to 70 percent of own revenues, and the Municipal Bankruptcy Law limits moral hazard in LG finances.

Reforms to local government arrangements are needed to the enhance the quality and efficiency of public services.2 Numerous regulations lay out the tasks of LGs, and also rigidly prescribe how they should be delivered. Central transfer arrangements are focused on inputs rather than outputs through detailed norms for funding. Weak administrative capacity partly accounts for shortfalls in local taxation relative to potential, along with very limited borrowing, such that investments have often fallen behind depreciation—most LGs are too small to undertake investments on a scale sufficient to reduce their operating costs. Steps including regulatory reforms to assure quality without micro-management, a reevaluation of appropriate level of government for the delivery of public services, and a simplification of the system of central transfers would likely contribute to efficiency, but the central government may also need to strengthen the current set of incentives for LG cooperation in service provision and administration, including perhaps by setting suitable conditions for access to EU grants.

1 The development of the structure of government is discussed in Lutz et al (1997).2 This discussion reflects technical work by the World Bank in cooperation with the authorities.

However, wages are relatively low in parts of the education sector, suggesting scope for reforms which address both issues, while potentially realizing some fiscal savings.

10. The path for defense spending is bound by agreement with NATO, though defense expenditures are being reformed. Hungary joined NATO on March 12, 1999 with an agreement to expand defense expenditure by 0.1 percent of GDP each year, to reach 1.8 percent of GDP by 2001, from 1.5 percent of GDP in 1998.6 The composition of spending is shifting from personnel towards capital expenditures.

B. Transfers to Households

11. Hungary’s social benefits are comprehensive, and they have been subject to various reforms, but targeting and tighter eligibility could improve their effectiveness. Total transfers to households amounted to 16.1 percent of GDP in 1998, including consumer subsidies (0.7 percent of GDP), and housing subsidies (0.4 percent of GDP). Pensions represented 7.8 percent of GDP, and the pension system is undergoing reforms to address the effects of population aging (Box 3). The remaining 7.2 percent of GDP are distributed under a range of programs, including: disability pensions for persons unable to work (1.0 percent of GDP); family and child care allowances (1.7 percent of GDP); sickness benefits, compensating for lost earnings (0.4 percent of GDP); and unemployment insurance and assistance (0.9 percent of GDP). To a varying degree, the effectiveness of these programs may benefit from targeting or tightened eligibility, as highlighted in the following.7

12. Family, maternity, and child-care benefits have been made universal and are being supplemented through the tax system. An attempt to introduce targeting of family allowances in 1995 was rejected by the constitutional court, but in April 1996 an income test was applied, though this only applied to 10 percent of families. This means test was eliminated in 1999, expanding coverage by 100–150 thousand children. Households with sufficient taxable earnings also benefit from child tax credits introduced in 1999. These changes have increased the share of overall benefits received by households that are not poor.

13. Disability pensions have widely recognized incentive problems, but reform plans have made limited progress. Through the 1990s the number of disability pensioners (under the retirement age) has risen from 204 to 425 thousand persons, some 10.4 percent of the labor force (Table 4) acting as a long-term unemployment benefit for some recipients. A parliamentary resolution in 1997 outlined the principles of disability pension reform including a focus on a workers’ remaining ability to work rather than on the loss of ability in a particular occupation-but this reform has not been implemented. Entry conditions were tightened to include a hospital test rather than a doctors report, but existing recipients are not reassessed. Implementation of further reforms would generate savings over time, but active labor market policies should be strengthened to assist people back into the labor force.

Table 4.

Old age and Disability Pensioners

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Source: Ministry of Finance and Central Statistical Office.

Pension Reform in Hungary

Pension reforms began in 1996, with adjustments to the pay-as-you-go (PAYG) system, including a gradual increase in the retirement age, and a shift in indexation formula. The PAYG system was then partly privatized in 1998, with PAYG members given the option to join a fully-funded, private pension fund—the “second pillar”. August 31, 1999 was the cut-off date for the second pillar, with 2 million persons joining, just over half the workforce—close to expectations. It is mandatory for future labor market entrants to join the second pillar. Voluntary pension funds were established in 1993, completing the multi-pillar system. Rocha and Palacios (1997) discuss the reforms in more detail.

Projections by Rocha and Palacios find that before reforms, pension expenditure would rise by some 5 percent of GDP from 2000 to 2050, with 1 percentage point in the next 10 years. The reforms would avoid this entire long-term increase, and even in the next 10 years would reduce spending by almost 3 percent of GDP relative to the baseline. The net fiscal saving is about 1¼ percent of GDP smaller in the long-run, because part of pension contributions are diverted to the 2 pillar. Though a long-run deficit in the pension system remains, at some 1½ percent of GDP by 2050, Benczur (1999) estimates that the reforms have cut the implicit debt burden from roughly 100 percent of GDP to 40 percent, equivalent to a permanent fiscal saving of approximately 1½ percent of GDP per annum.

Hungary—Impact of Public Pension System Reform

(In percent of GDP)

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Source: Rocha and Palacios (1997).

For employees entering the second pillar, a part of the regular pension contribution (30 percent of gross wages in 1999) is redirected to their private pension fund. This portion was initially set to 6 percent of gross wages, and was scheduled to rise to 7 percent in 1999, and to 8 percent in 2000. However, due to the revenue loss to the budget—some 0.1 percent of GDP for each percentage point—the authorities will leave the rate of contribution to the private funds at 6 percent in 2000, with no new schedule to reach 8 percent yet announced. As discussed in Annex II, this revenue loss does not imply a weaker fiscal stance, due to the offsetting increase in private savings. The longer the increase is delayed, the larger the number of people who may eventually need to draw on the guarantee fund—which supplements the 2nd pillar pensions of those who would receive less than ¾ of the PAYG pension. Projections attached to the 2000 budget suggest that a delay until 2003 would significantly deplete the guarantee fund in 2013–16, but it would be manageable. However, there is also a risk that considering the uncertainty in the funds to be contributed to their accounts in the private funds, some 2nd pillar entrants will switch back to the PAYG system in 2000. This would weaken the outlook for the PAYG system, and undermine the benefits of the reform.

14. Sickness payments may exacerbate the high rate of sick leave. These payments compensate employees for lost earnings due to sickness. A reform in 1992 required employers to pay for the first 10 days of absence, which was extended to 15 days in 1996, with the payment reduced to 75 percent of gross wages from 85 percent previously. Compensated sick days per employee fell from 25–30 days to 16.5 days more recently, but this remains high compared with the U.S. and the Netherlands at 5–6 days. Estimates of lost productivity of some 1.7 percent of GDP (World Bank, 1999), indicate that further reform steps may be desirable.

C. Public Investment

15. Public investment (3.6 percent of GDP in 2000) may need to rise over time due to infrastructural investments.8 Analysis of regional issues in Hungary indicates a strong connection between investment, FDI, and the quality of infrastructure (Annex I). A more effective transport infrastructure has been identified as key to assisting the East of Hungary participate in the rapid economic development that is currently benefiting primarily the Northwest and Budapest regions. The government has a 10 year motorway construction plan, involving total expenditures of 7 percent of the 1998 level of GDP (Table 5). To execute this program, the Hungarian Development Bank has established the National Motorway Shareholding Company, which is to be funded by a mixture of transfers from the central budget, EU assistance, and state guaranteed loans. Toll revenues are designed to cover operations and maintenance expenses, so other costs like debt service would eventually need to be covered by the budget, implying that the total budgetary obligation in annual terms may rise by some 0.3 percent of GDP more than the transfer for construction expenses.

Table 5.

Hungary: 10-Year Motorway Plan-Construction and Other Costs

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Sources: Ministry of Transport and staff estimates.

16. Investments required to meet EU environmental standards are large, but estimates vary widely. The most important issues to be addressed are water quality improvement, waste treatment, and air pollution from the energy sector and vehicles.9 The ultimate costs of complying with EU standards are rather uncertain, with estimates ranging from 1.7 percent to 4.5 percent of 1997 GDP per annum.10 Waste water treatment is the area of greatest cost, which will fall primarily on local governments. To ensure effective environmental regulation, the National Environmental Program was adopted in 1997, with a planned rise in expenditures from 1 percent of GDP in 1996 to 1.4 percent of GDP by 2000–02.

III. Issues in Designing a Medium-term Fiscal Framework

17. A medium-term fiscal framework may assist in evaluating the preferred approach to managing this range of expenditure pressures and structural reform issues. As discussed in Section II, Hungary faces a multi-faceted medium-term fiscal challenge from EU accession among other factors. A medium-term fiscal framework can be used to analyze the economic implications of various approaches to managing such shocks, and this is the focus of Section IV. The focus of a medium-term framework is typically on the fiscal balances consistent with a sustainable macroeconomic path. However, the level and structure of revenues and expenditures also have medium to long-run consequences for economic growth, where strong growth is a high priority for the Hungarian authorities. The following first outlines the factors guiding decisions on the medium-term fiscal stance in Hungary, and then discusses the state of research on growth effects from the structure of fiscal policy, with a view to incorporating these into a medium-term fiscal framework.

A. Determining the Medium-term Fiscal Position

18. In addition to the sustainability of public debt, Hungary needs to evaluate the sustainability of the external current account in determining the medium-term fiscal position as the main guiding rule for fiscal policy. Analysis of the sustainable fiscal stance typically focuses on whether it can be financed at an acceptable inflation rate without a trend rise in public debt ratios. However, experience in Hungary and other countries suggests that the external current account balance, and in particular the requirement for debt-creating financing, will also be a factor constraining the macroeconomic stance because investors are averse to unsustainable trends in external debt. As discussed below, external current account sustainability is likely the binding constraint on the fiscal stance in the medium-term, and the importance of this issue implies that a fiscal deficit path will be the key rule for policy over the medium-term. This is also consistent with Hungary’s strong orientation toward EU convergence.

19. The current fiscal stance is adequate to stabilize the public debt ratio without ongoing inflows of nondebt budget financing. With a substantial contribution from privatization, the public debt in Hungary has been cut from nearly 90 percent of GDP in 1993 to some 61 percent of GDP at end 1999. To avoid a reversal of this downtrend in the public debt ratio, the primary balance (p) must be at least the value from the usual formula:


Where r=real interest rate, g=real GDP growth rate, D=public debt in percent of GDP, and a=nondebt financing in percent of GDP. The real interest rate (on the basis of the GDP deflator) is assumed to be 5 percent-similar to the average level in 1996–99—while the potential real GDP growth rate is assumed to be 4½ percent (Box 4). Assuming no privatization revenues, the required primary surplus is therefore 0.3 percent of GDP. While the primary surplus is 1.6 percent of GDP in 1998 on an official basis, the NBH estimates the primary surplus at 0.6 percent of GDP on a national accounts basis and accrual approach, as further discussed in (Annex II).11 Preliminary data for 1999 show a primary surplus of some ¾ percent of GDP, so the current fiscal stance should generate a trend decline in the public debt burden. Such a debt decline is not driven by the need to make room for a future rise in expenditures arising from demographic pressures, because these are being addressed directly by pension reform and reforms are also feasible in the case of healthcare. Rather, debt reduction will further reduce risk premia and support growth (van der Ploeg, 1996).

20. The Hungarian authorities aim to maintain the external current account deficit at around 4 percent of GDP, which can be considered sustainable.12 The current account deficit that stabilizes the net foreign debt to GDP (NFD) is given by the following formula:


Where ca = external current account deficit, g* is growth of GDP in foreign currency terms, and nd = net nondebt-creating BOP financing, which includes foreign direct investment. With 4½ percent potential real GDP growth, foreign inflation on a GDP deflator basis of 1 percent, and assuming a stable real exchange rate on a GDP deflator basis, the external current account deficit may exceed FDI and other nondebt inflows by 1¼ percent of GDP per annum, given net foreign debt to GDP estimated at 24 percent at end 1999.13 As discussed in (Annex 1), FDI inflows are subject to some uncertainty, but a prudent assumption for the medium-term would be in the order of 3 percent of GDP per annum. A current account deficit of 4 percent of GDP deficit would therefore result in a gradual reduction in net foreign debt to GDP, which is appropriate considering that Hungary’s debt is somewhat higher than typical of middle-income countries with an investment grade rating (Beaumont, 1999).

Potential Growth in Hungary

Hungary would appear well placed to sustain high growth rates in the medium-term. van Elkan (1997) estimated that with inflation falling, strong FDI inflows, the progressive liberalization of external trade, and the labor force increasingly well educated, that growth could accelerate to 5–6 percent. In the event, growth was close to 5 percent in 1997–98, and the slowdown to 4 percent in 1999 reflects weak external demand in the EU and flooding effects on agriculture. Recovery in the EU is expected to lift growth to some 4½ percent in 2000, and the authorities estimate that growth with accelerate to some 5 percent in 2001 and 5–6 percent in 2002 (Hungarian Budget Directives, 1999).

Productivity rises could permit high growth in the medium-term, but there is significant uncertainty about how rapidly productivity will rise. An initial application of the growth accounting approach by Hviding (1998) explores the conditions that would allow growth of 5–5¼ percent in the medium-term. The following conditions are sufficient: fixed investment growth of 8 percent; a rise in labor force participation to offset declines in the working age population; and total factor productivity (TFP) growth of 2½ percent. This latter growth rate is similar to that seen in many emerging market economies, but below the post-war experience 3–3½ percent in Germany, France, Italy and Japan. The required rise in the participation rate, from 61 percent in 1997 to 70 percent by 2002, is quite rapid, suggesting some downside risk to the potential growth estimate.

Research underway at the National Bank of Hungary suggests a broadly similar potential growth rate in the medium-term. The NBH also uses a growth accounting framework, but is able to produce more sophisticated estimates of the capital stock. In particular, the NBH finds a smaller reduction in the effective capital stock in 1990–91 due to the collapse of CMEA trade. Analysis of the labor force cohorts supports the expectation for slow employment growth despite a falling population, with a rising level of skills on average. The main engine of growth is found to be the rising net capital stock, which is expected to permit average growth of 4 to 5 percent in the medium-term. Recent research using statistical decomposition techniques also estimates potential growth rates in this range in recent years.

As in more advanced economies, estimates of potential growth will need to be updated regularly, and the greater uncertainty of these estimates must be reflected in the design of economic policies. Medium-term fiscal projections are often based on somewhat conservative estimates of potential growth. For Hungary, a potential growth rate of some 4½ percent appears to be supported by a variety of analysis. While actual growth rates could be higher, a fiscal policy based on this assumption reduces the risk that lower than assumed growth rates will undermine the fiscal balances, putting pressure on inflation and the external current account deficit.

21. The expected rise in private investment relative to private savings requires a further consolidation of the fiscal position. The external current account deficit in 1998 was 4¾ percent of GDP, and the preliminary out-turn in 1999 is 4½ a percent of GDP. While these are relatively close to the authorities’ medium-term goal, a strong rise in private investment is anticipated in coming years, most likely exceeding the total rise in corporate and household savings. Private saving and investment prospects are examined in Annex III, which suggests that a fiscal tightening on the order of 1 percentage point of GDP may be needed in the medium-term to keep the average current account deficit broadly on target. However, there is substantial uncertainty in the outlook for private investment, corporate profits, and household savings, and thus the appropriate path for the fiscal balance-the implications for fiscal management are considered below.

B. Macroeconomic Effects from the Structure of Fiscal Policy

22. The structure of fiscal policy, as reflected in the level and composition of revenues and expenditures, could significantly shape the pace at which Hungarian incomes converge toward EU levels. Endogenous growth models suggest that there is an optimal size for government in terms of economic growth, where the costs-from tax distortions begin to outweigh the benefits from public expenditures (Barro, 1990). The large empirical literature that stems from these models is surveyed by Gerson (1998). The range of estimates for the growth effects of fiscal policy is wide, but the following points can be made regarding the impact of fiscal variables on growth:

  • Health and education status are important for growth, but the link to spending is found to be weaker, presumably reflecting gestation lags and varying degrees of efficiency in the provision of services.

  • Social transfers may have quite different effects depending on their level and design, with positive effects stemming from enhanced political stability, but negative effects from disincentives to employment.

  • A higher tax burden reduces labor force participation, especially among secondary workers, with a 1 percent of GDP increase in the tax share reducing the employment rate by 0.3 to 0.5 percent in the long-run, Habermeier and Lenseigne (1998).

  • The elasticity of GDP with respect to public capital is commonly estimated at between 0.2 to 0.3, Ligthart (1999). Sturm (1998) finds that transport infrastructure raises GDP with a lag, and other infrastructure stimulates machinery investment.

23. Recent research may offer somewhat more robust statistical evidence on the magnitude of fiscal policy effects on economic growth. Kneller et al (1999) follow the structure of the endogenous growth models, by disaggregating expenditures into two types: productive”—those that enter the private sector production function-which include public services, health and education, transport and communication; and, “nonproductive”, primarily social security and welfare expenditures. Similarly, taxes are disaggregated into those which distort production and investment decisions (taxes on income and profits, social security contributions and payroll taxes) and “nondistortionary” taxes (taxes on domestic goods and services). Their empirical analysis of OECD countries pays careful attention to the implications of the government budget constraint. Distortionary taxes are found to reduce growth, by an average of -0.3 percent per annum for a 1 percent of GDP increase in taxes, while nondistortionary taxes have no significant effect. Productive expenditures are found to increase growth, by an average of 0.2 percent per annum, while nonproductive expenditures have a limited impact. Therefore, a 1 percent of GDP cut in distortionary taxation financed by cutting nonproductive expenditures can raise growth by some 0.3 percent per annum, but only 0.1 percent per annum if financed by cutting productive expenditures. These estimates are found to be reasonably robust to a variety of empirical specifications, though the authors urge caution in predicting the precise growth effects of fiscal changes.

24. Private savings and investment are responsive to the structure of fiscal policy, but the impact on the private sector savings-investment balance is unclear. Research outlined in Box 5 suggests quite strong effects from the level and composition of revenues and expenditures on private saving and investment. A number of papers suggest that a reduction in current spending by 1 percent of GDP, with a matching reduction in revenues—such that the fiscal deficit is unchanged—may increase private savings by 0.4 to 0.6 percent of GDP.14 Alesina et al (1999) finds that private investment may rise by as much as 1 percent of GDP after five years, primarily because a simultaneous reduction in spending and revenues is found to increase corporate profits. The investment response is sensitive to the composition of the expenditure and revenue changes, being much larger if the public wage bill is reduced so that labor taxes can be eased. However, the literature on investment responses is less developed than that for saving, making it difficult to reach a conclusion on the impact of fiscal reforms on the balance of private savings and investment.

25. This research suggests that the structure of fiscal policy does affect growth, savings, and investment, though there is significant uncertainty about the magnitude of these effects. This brief survey suggests that the rate of economic growth is significantly responsive to the structure of fiscal policy, and savings effects are found in a number of studies, but the empirical literature on investment responses appears to be at an early stage. These results are therefore applied in a cautious manner in the following section.

Fiscal Policy and Private Savings and Investment

The effect of the fiscal balance on private sector savings has been subject to much research testing for Ricardian equivalence. Ricardian effects are sometimes found to be large in advanced economies, with changes in private saving offsetting as much as 90 percent of changes in public saving in Ul Haque et al (1999). These effects appear less strong for low- or middle-income countries (with a 40 to 50 percent private savings offset) likely reflecting less developed financial markets among other factors, see Masson et al (1995). In addition to the fiscal balance, the level and composition of expenditure and taxation may affect private savings and investment, as discussed below.

UI Haque et al find that the level of current government expenditures is a key determinant of private savings. An increase in current spending ratio to GDP by 1 percentage point is found to reduce the private savings ratio by 0.4 to 0.6 percentage points, similar to Masson et al (1995). This effect—for a given fiscal balance—may reflect higher taxation reducing disposable income and incentives to save, a stronger redistribution of incomes from higher to lower saving households, and weaker precautionary motives to save due a more generous social safety net. Callen and Thimann (1997) emphasize the importance of effects from income taxation and the generosity of the social security and welfare system on household saving. Public investment, to the extent that it is viewed as generating future revenues for the government, might not be expected to require further taxes, and hence would not generate a private savings response. The empirical results are less clear-cut for public investment, but Ul Haque et al find a similar though statistically less significant effect to current expenditures, while Masson et al are often able to accept the restriction that the effects are the same. Overall, these results would suggest that the expansion of savings due to an expenditure-led fiscal consolidation may broadly offset the contraction due to Ricardian effects, at least in middle income countries.

Alesina et al (1999) find large negative effects from public spending on private investment in the OECD countries. These effects are felt over a number of years, and differ significantly across different types of public expenditure, as shown in the following estimates:

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A permanent cut in both expenditures and revenues by 1 percent of GDP is therefore estimated to increase the private investment ratio by close to 1 percentage point after 5 years. The impact is larger still if public wage expenditures are reduced, at the same time reducing labor taxes. The effects on investment are found to work primarily by increasing labor supply, thereby strengthening corporate profits. Alesina et al suggest these results help explain why some fiscal consolidations had expansionary effects, because they were cases of cuts in wage and transfer expenditures, rather than increases in taxes. Caution regarding the magnitude of these investment effects is warranted, because the literature is less developed than for savings. It is therefore difficult to know whether a matching reduction in expenditures and revenues will raise or lower the private savings-investment balance.

IV. Fiscal Strategies on the Road to eu Accession

26. This section presents scenarios illustrating the tensions in fiscal policy, and the potential role for medium-term expenditure restraint to achieve fiscal objectives while facilitating growth. Starting from the 2000 budget, the scenarios cover 2001–03, though they would also have implications for economic performance in later years. Both scenarios assume that commitments made in key policy areas, including pensions, defense, and EU accession are met, and also that the fiscal stance is adjusted to ensure sustainable economic performance—indeed the fiscal deficit paths are the same in each case. The focus of the analysis is the different way in which these goals are achieved. In the baseline scenario, the growth in expenditures in categories outside these commitments assumes no new policy reforms. These results are contrasted with a reform scenario, which includes higher expenditures on infrastructure and healthcare, but where restraint in other expenditures facilitates tax reforms.

27. The scenarios presented are not projections, rather they are intended to illustrate the potential gains from continued structural reform efforts in the general government. The baseline scenario may be considered moderately conservative, which as discussed below, is likely the best starting point in the face of significant uncertainty. The next section discusses the treatment of public spending and pension reform in the scenarios, along with the factors affecting revenues. The second section presents and contrasts the two scenarios, followed by a discussion of how to handle uncertainty with respect to macroeconomic and fiscal developments.

A. The Treatment of Public Expenditure, Pensions, and Revenues

28. Some expenditure components are strongly precommited in Hungary, suggesting that they be treated separately. In addition to interest payments, the key components of public spending bound by precommitments include old-age pensions under the pension reform, and defense spending under arrangements with NATO. Capital expenditure is best treated separately because there are needs for infrastructure to support growth and to comply with EU environmental standards. Healthcare expenditures—excluding pharmaceutical subsidies—must also be analyzed separately, considering that addressing the long-term implicit liability in this sector may require additional expenditure in the medium-term, as discussed in Section II. Finally, given the high priority attached to timely EU accession, expenditures for legal approximation and institution building required to adopt the Acquis Communautaire are also separately identified.15

29. The analysis therefore focuses on projecting these pre-committed items, and on exploring the implications of alternative paths for the more flexible or “discretionary” expenditure components. Current primary spending excluding the above pre-committed items is denoted for convenience as “discretionary” expenditure. Discretionary expenditure was some 24 percent of GDP in 1998, of which public sector wages (outside healthcare) were some 6.4 percent of GDP (27 percent), social security and welfare services (excluding old-age pensions) were some 7.5 percent of GDP (31 percent), while the remainder is dominated by goods and services. Some 60 percent of this expenditure is therefore linked to wage developments, because most social benefits are linked to the minimum pension, which is indexed to wages.

30. In anything but the very short-term, expenditure restraint within the discretionary component of spending can only be sustained through structural reforms that either reduce the obligations of the public sector, or improve the efficiency of public services. Social benefits form a substantial part of discretionary current spending: though these expenditures are not closely controlled by policymakers within any budget year, they can be managed over the medium-term by altering eligibility rules among other reforms. Even in areas more amenable to short-term restraint, it should be recognized that expenditure goals supported by structural reforms will prove to be more sustainable than spending caps. This is true in an area such as the public sector wage bill, where average wages in some areas have been squeezed to low levels, and where future efforts need to focus on reducing staff numbers in areas with low productivity, e.g., education, while retaining the flexibility to employ persons with the requisite skills, e.g., demand for foreign language skills will increase due to EU accession.

31. Each scenario presents the fiscal balances both with and without completion of the pension reform in the medium-term. While most elements of the pension reform are complete, the proportion of social security contributions to be transferred to the private pension funds has not yet reached the final level. This transfer was to have increased from 6 percent of the base for social contributions in 1998, to 7 percent in 1999, and 8 percent in 2000. However, this increase has been delayed, with the rate of transfer remaining at 6 percent in 2000.16 Each scenario is presented with the transfer rate remaining at 6 percent, and also with an increase to 7 percent in 2001, and 8 percent in 2002. The underlying stance of fiscal policy is the same with or without completion of the pension reform, but in the former case the fiscal balances are lowered by the additional transfers to the private fund.17

32. Revenues are under pressure from implementation of WTO agreements among other sources. Customs revenues are projected by the Ministry of Finance to fall from 1.3 percent of GDP in 1999 to 0.6 percent of GDP by 2002 as tariff rates are cut to the levels agreed under the Uruguay round. Receipts from asset sales included within official primary revenues are expected to fall sharply in 2000, from 1.2 to 0.5 percent of GDP, and it is assumed that these receipts remain at this lower level in later years.18 On top of these factors, the volume of social security contributions that are transferred to the private pension funds is rising, from a projected 0.5 percent of GDP in 1999 to 0.7 percent of GDP by 2003 with no increase from the 6 percent rate, or to 0.9 percent of GDP with the increase to an 8 percent rate. Therefore, level of primary revenues is adjusted to exclude customs revenues and asset related receipts, and also for pension reform losses, to indicate the scope for changing the tax burden.

B. Scenario Comparison

33. The 2000 budget is the starting point for the medium-term analysis. The budget for 2000 targets an overall fiscal deficit of 3½ percent of GDP. The tightening in the fiscal stance from the projected 1999 out-turn is estimated at a modest ¼ percent of GDP, Table 6, such that there may be a small rise in the external current account deficit due to the expected acceleration in private investment.19 A significant cut in the primary revenue ratio is also planned, by some 1.1 percentage points of GDP, reflecting an expected fall in receipts from asset sales and customs revenues, while other revenues are stable as a share of GDP. Therefore, to achieve the targeted fiscal tightening, the 2000 budget relies on firm expenditure restraint in order to reduce the ratio of current primary expenditure to GDP by some 1.2 percentage points from the level expected in 1999. With a sharp rise in EU accession costs, discretionary expenditures are to be cut by 1.4 percentage points of GDP, or by 2.2 percent in real terms.

Table 6.

Hungary: Baseline Fiscal Scenario

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Sources: Ministry of Finance and staff estimates until 1998; staff projections after 1998.

Revenues are exclusive of EU transfers--expected precession transfers are netted against spending for accession purposes.

Includes survivor benefits. Projections from Fifty-year Pension Forecast attached to 2000 budget.

Estimates for central government from National Program for Adoption of the Acquits for 1999–2001, staff estimates for other years.

Expenditures on public health services. Does not include pharmaceutical subsidies, or payments for maternity or sick leave.

Preliminary staff estimates, as discussed in Annex 2.

Projections assume no increase in the rate of transfer to the private funds from the present 6 percent level.

34. The medium-term path for the fiscal balance in both scenarios is broadly consistent with the tighter end of the authorities’ medium-term target range for the official general government deficit. The scenarios incorporate the fiscal stance discussed in Annex III, with a cumulative fiscal withdrawal of 1 percent of GDP spread over 2001–2003. Allowing for the pension reform to be completed in 2001–02, this tightening would reduce the official fiscal deficit to some 2 percent of GDP by 2002, consistent with the tighter end of the target range in the Medium-term Budget Directives, MOF (1999).20

The estimated overall fiscal deficit on a National Accounts (SNA) basis would be cut to less than 3 percent of GDP by 2003.21

35. Two scenarios for public spending growth are considered. The baseline scenario represents no structural change in fiscal policy, but firm implementation of current policies for discretionary spending, while the reform scenario envisages a range of reforms to underpin restraint in discretionary spending, which is coupled with tax and healthcare reforms, and a rise in public investment. Box 6 notes the technical assumptions common to both scenarios.

36. Without expenditure reforms, there is little or no room to raise public investment implement healthcare reform, or cut the tax burden in the medium term. The baseline scenario assumes that real discretionary expenditure growth is some 2½ percent per annum over 2001–03 (Tables 6 and 7). This estimate reflects the fact that the majority of these expenditures are wage-related, along with the expectation that labor productivity will grow at some 3 percent, and the assumption that public sector wage rates will not be further reduced relative to the private sector in the medium-term.22 Significant fiscal discipline will be required to achieve this baseline expenditure path. It is also assumed that public capital spending remains constant as a share of GDP. Under this scenario, discretionary spending would be cut by 1.2 percentage points of GDP in 2000–03, and total primary expenditure falls by 1.5 percentage points—because the projected decline in pension expenditures outweighs rising costs from EU accession and defense. However, these savings are needed to compensate for lost customs revenues and to make the targeted tightening in the fiscal stance, leaving no room for tax cuts—adjusted primary revenues are stable at 40.4 percent of GDP.

Table 7.

Hungary: Fiscal Scenario Comparison

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Sources: Ministry of Finance, National Bank of Hungary, and staff projections.

Adjusted for the transfer of savings from the public to private sectors due to the pension reform.

Indicator of change in tax burden, given by primary revenues excluding customs revenues and asset related receipts, adjusted for losses due to pension reform.

Current primary expenditure excluding projected spending on old-age pensions, defense, healthcare, and EU accession.

Based on preliminary staff estimates of the deviation between official fiscal balances and balances on an SNA methodology.

The fiscal stance is the same with or without completion of the pension reform in 2001–02.

37. The baseline scenario fails to make progress towards the fiscal goals of the Hungarian authorities. The of the Ministry of Finance (attached to the Budget for 2000) targets a reduction in primary revenues from a budgeted 41.3 percent of GDP in 2000 to 38.5 percent of GDP in 2002, some 2.8 percentage points of GDP. However, in the baseline scenario primary revenues fall only I percentage point of GDP, and this is due to lower customs and asset-related receipts, rather than a lower tax burden. The baseline scenario also does not allow for higher infrastructural investment, and together with the unchanged tax burden, this scenario is not supportive of economic growth.

38. To reduce taxes and raise public investment, a wide range of reforms would be required. The key reforms would be in the areas of: (1) healthcare, involving the definition of a core benefit package for healthcare services, reforms to pharmaceutical subsidies, and an active purchaser approach by the Health Insurance Fund; (2) targeting of various social benefits, including support for families, and reforms to disability pensions and sickness payments; and, (3) improved arrangements for local government financing and responsibilities—a prerequisite for greater efficiency in education and in healthcare over the longer term (Box 20).

Technical Assumptions for the Scenarios

A number of working assumptions are made that are common to both scenarios:

1. Large inflows of EU transfers that would follow accession are not assumed to occur during the 2000–2003 period. There are more modest pre-accession inflows which cover some EU preparation costs. The scenarios assume that this EU assistance remains at some ¾ percent of GDP, based on the National Program for the Adoption of the Acquis, and these inflows are netted from EU accession related expenditures.

2. Expenditures for EU Accession financed by central government are estimated in the National Program for the Adoption of the Acquis at some Ft 77.5 billion in 1999, Ft 141.1 billion in 2000, and Ft 168.8 billion in 2001. It is assumed that there are also ongoing costs in 2002 and 2003 in the same order of magnitude as a share of GDP as in 2001.

3. Pension expenditure is assumed to follow the path in the 50-year projection attached to the 2000 budget.

4. Healthcare expenditures are assumed to remain stable as a share of GDP in the baseline, though they decline by 0.4 percentage points of GDP in the Three-Year Prognosis.

5. NATO commitments imply that defense expenditures increase by 0.1 percentage points of GDP in 2000 and 2001, to reach 1.81 percent of GDP on an ongoing basis.

6. Net interest payments start from the 2000 budget projection, and then decline similarly to the Three-Year Prognosis for 2001–2002.

7. Inventory investment is assumed to remain at the estimated 1998 level as a share of GDP, because the ultimate nature of this national accounts item is unclear.

8. Inflation on a CPI basis is expected to settle at around 4 percent by 2002–2003, and in the GDP deflator at about 3 percent, in each case allowing for contributions from an initial unit labor cost differential and the Balassa-Samuelson effect.

9. The overall deficit is financed completely by new debt issues, by assuming that future privatization receipts cover various contingent liabilities—including contractual guarantees on past privatization, local government claims on privatization proceeds, losses by the Hungarian Development Bank, and expenditures preparing state enterprises for privatization.

10. FDI inflows on a gross basis in 1999–2003 are assumed to be 3 percent of GDP, the level observed in 1995–98 when excluding privatization receipts—see Annex I. Net inflows of portfolio equity are assumed to broadly balance outflows of direct investment, so net nondebt-creating inflows are also 3 percent of GDP.

39. The reform scenario assumes that comprehensive implementation of such reforms would allow discretionary spending to be held constant in real terms. The resulting expenditure savings rise to 1.7 percent of GDP per annum relative to the baseline scenario by 2003 (Table 8). These savings are used as follows:

  • Healthcare expenditure rises by 0.3 percent of GDP by 2003, principally on overdue investments and repairs, as part of a comprehensive reform which aims to contain larger longer-term expenditure pressures (see Section II).

  • Public investments rise by 0.4 percent of GDP, including to fund the 10-year motorway construction program, which will have additional budgetary costs besides the transfers for construction expenditures (see Section II).

  • The tax burden is reduced by 1.1 percent of GDP. This would facilitate the introduction of a reform package that would introduce new taxes, e.g., a municipal tax on property values—which could yield some 2 percent of GDP—and taxation of interest and insurance, while cutting the high labor tax rates significantly.23

Table 8.

Hungary: Fiscal Reform Scenario

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Sources: Ministry of Finance and staff estimates until 1998; staff projections after 1998.

Revenues are exclusive of EU transfers—expected preaccession transfers are netted against spending for accession purposes.

Includes survivor benefits, Projections from Fifty-year Pension Forecast attached to 2000 budget.

Estimates for central government from National Program for Adoption of the Acquis for 1999–2001, staff estimates for other years.

Expenditures on public health services. Does not include pharmaceutical subsidies, or payments for maternity or sick leave.

Preliminary staff estimates, as discussed in Annex 2.

Projections assume no increase in the rate of transfer to the private funds from the present 6 percent level.

40. Achieving this set of fiscal reforms would promote growth through a variety of channels. The largest contribution would come from tax reforms focused on reducing the high burden of labor taxes, which would be only partly offset by the effect of increases in less distortionary taxes. Thus labor force participation and human capital investments would be increased, while bringing more of the large gray market economy back into the fiscal net. The estimated impact of the reform scenario on private savings and investment is presented in Annex III (Table 17). As noted above, the magnitude and timing of the private investment response is rather uncertain, and it has been constrained to be in line with the savings response, at 0.6 percent of GDP by 2003—this assumption allows the targeted fiscal stance to be the same in the two scenarios. Higher public infrastructure investment should improve the productivity of existing private capital, and altogether these effects are estimated to add some ½ percentage point to the annual growth rate over the medium-term.24 A stronger growth effect would be generated if improved infrastructure also led to higher FDI inflows. A sustained rise in investment financed by FDI does not call for a tighter fiscal stance to contain the associated rise in the external current account deficit, because net foreign debt is unaffected (Table 9).

Table 9.

Hungary: Fiscal Reform Scenario with FDI Response

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Sources; Ministry of Finance and staff estimates until 1998; staff projections after 1998.

Revenues are exclusive of EU transfers--expected preaccession transfers are netted against spending for accession purposes.

Includes survivor benefits. Projections from Fifty-year Pension Forecast attached to 2000 budget.

Estimates for central government from National Program for Adoption of the Acquis for 1999–2001, staff estimates for other years.

Expenditures on public health services. Does not include pharmaceutical subsidies, or payments for maternity or sick leave.

Preliminary staff estimates, as discussed in Annex 2.

Projections assume no increase in the rate of transfer to the private funds from the present 6 percent level.