Hungary: Selected Issues

The two legs that have held up the forint in recent years—a strong “EU accession effect” and positive sentiment toward emerging markets—may no longer be strong enough to offset Hungary’s weak fundamentals. Fiscal consolidation efforts should be supported by stronger budget controls and greater transparency and accountability. This paper is an effort to shed light on Hungary’s employment dynamics, placed in the European Union (EU) context. Hungary’s employment generation has been relatively strong, partly owing to the country’s favorable initial employment distribution across sectors.

Abstract

The two legs that have held up the forint in recent years—a strong “EU accession effect” and positive sentiment toward emerging markets—may no longer be strong enough to offset Hungary’s weak fundamentals. Fiscal consolidation efforts should be supported by stronger budget controls and greater transparency and accountability. This paper is an effort to shed light on Hungary’s employment dynamics, placed in the European Union (EU) context. Hungary’s employment generation has been relatively strong, partly owing to the country’s favorable initial employment distribution across sectors.

II. HungaryDeveloping a Medium-Term Fiscal Strategy5

A. Introduction

29. Fiscal and external imbalances are eroding growth potential and exacerbating vulnerabilities. Hungary today has the largest fiscal and current account deficits among sizable emerging markets, its public and external debt ratios have grown steadily in recent years, and foreign-currency mismatches are rapidly increasing. Following robust performance in 1997-2001, growth has slowed and is expected to lag behind regional peers in the years ahead. Reflecting concerns over rising vulnerabilities, financial markets have begun to differentiate Hungary. Economic and financial buffers built over the last decade offer some protection from a further slide in the currency and higher interest rates. However, if these safeguards weaken and global sentiment worsens, serious consequences could follow.

30. In response to this alarmingly poor fiscal situation, the authorities announced an ambitious adjustment package in mid-2006. Under a no-policy-change scenario, the 2006 fiscal deficit could reach 11 percent of GDP on a European System of Accounts 1995 (ESA 95) basis, compared with a target of 6.4 percent of GDP.6 In response, the authorities announced an adjustment package that aims to bring the deficit down to the Maastricht limit of 3 percent of GDP by 2008. While the package contains some measures based on long-term principles, it relies heavily on higher taxes on labor and capital, which may not achieve the anticipated revenues, may complicate tax administration, and could be detrimental to growth potential and competitiveness. Fiscal consolidation efforts would, in that case, be undermined, requiring the authorities to undo the tax increases without having found a permanent solution for stabilizing public finances.

31. Placing public finances on a sound footing will require sustaining consolidation beyond the authorities’ plans and improving the quality of the adjustment strategy. A fiscal consolidation in line with the authorities’ plans but extended until 2010 would reverse the rising trend in the public debt-to-GDP ratio and bring it beneath the Maastricht limit of 60 percent of GDP. If accompanied by a significant reduction in government expenditure and an improvement in efficiency and targeting, the consolidation would elevate long-term growth potential by restoring macroeconomic balance, enhancing economic efficiency, and encouraging private savings. Given that fiscal consolidation needs are so large, revenues have to be increased, but the opportunity should be used to achieve a more stable and broad-based tax system. Fiscal consolidation should also be accompanied by greater transparency and accountability and supported by stronger budget controls.

32. This paper proposes a medium-term strategy aiming to achieve a sustainable and growth-promoting fiscal consolidation. Section B discusses recent fiscal developments and fiscal consolidation needs, building the case for more ambitious and better-quality fiscal adjustment. Section C presents a medium-term strategy for fiscal reforms that would support consolidation and long-term growth. The first subsection deals with expenditure policy issues, the second with tax policy and tax administration reforms, and the third subsection with fiscal transparency and accountability. Section D concludes.

B. Recent Fiscal Developments and Fiscal Adjustment Needs

33. Fiscal consolidation has been elusive in recent years. The fiscal deficit climbed to 7.6 percent of GDP in 2005, from 6.5 percent of GDP in 2004 and about 4 percent in 2001. The deterioration in the fiscal position over time reflects mainly an increase in primary current spending, driven by transfers to households, and also a decline in tax collection (Table 1). Capital expenditures have been compressed. After a substantial reduction in the 1990s, public debt has steadily increased since 2001, reaching 62 percent of GDP in 2005. On the positive side, public debt has long maturities and low foreign currency exposure, mitigating rollover risk and the costs of a large depreciation.

Table 1.

Hungary: Consolidated General Government, 2002-06 1

(In percent of GDP)

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Sources: Hungarian authorities; and staff estimates.

Data are classified following the ESA 95 methodology.

Including social security contributions.

Including the cost of aircraft lease in 2006 of 0.3 percent of GDP.

34. On current trends, the 2006 fiscal deficit and public debt will continue to rise. As noted, the 2006 fiscal deficit could reach 11 percent of GDP on an ESA 95 basis, almost double the original target. The substantial deviation from the target reflects both endemic slippages in some expenditure (e.g., subsidies) and “one-off items (e.g., emergency spending for floods and higher expenditures of local governments due to upcoming elections). The impact of expenditure overruns is compounded by a projected decline in tax revenues, given shortfalls from social security contributions and the 2005 tax reform.7 Absent action, the public-debt-to GDP ratio would rise to nearly 70 percent by end-2006. Even if the authorities’ package is fully implemented, public debt would remain above 60 percent of GDP in 2010.

35. To reverse the upward trend in public debt, a cumulative reduction of 10 percent of GDP in the primary balance is needed over the next four years. To meet the Maastricht fiscal deficit limit, a fiscal consolidation in the primary balance of 7 percent of GDP would be required. However, to reverse the upward trend in public debt and bring the debt-to-GDP ratio down to under 60 percent by 2010, a more ambitious fiscal consolidation in the primary balance of 10 percent of GDP is necessary. This effort is comparable in magnitude in the early phase to that proposed by the authorities, but stretches the consolidation by over two years. In addition, a greater reliance on expenditure consolidation, with revenues raised by broadening the tax base and addressing inefficiencies, would elevate long-term growth potential. The international experience with large fiscal adjustments supports this approach (Box 1). Under staffs preferred scenario, public debt declines to under 60 percent of GDP, and growth, while suffering in the short run, recovers to 4.5 percent by the end of the period.8

C. A Medium-Term Fiscal Strategy for Sustainable Growth

36. This section proposes a medium-term strategy aiming to achieve a sustainable and growth-promoting fiscal consolidation. A strategy focused on significantly reducing government expenditure, broadening the tax base, and improving transparency and accountability would increase the sustainability of the adjustment and support long-term growth potential. The first subsection discusses issues in expenditure policy; the next addresses issues in revenue policy and administration; and the third subsection deals with fiscal transparency and accountability.

Improving the efficiency and targeting of public spending

37. Reducing current spending and improving the efficiency and targeting of public services will need to be at the heart of fiscal consolidation efforts. As noted above, the deterioration in the fiscal position has been primarily driven by rising current primary spending.

Fiscal Adjustment in European Union (EU) Countries

Almost all EU countries went through episodes of significant fiscal consolidation in the 1990s; some countries had already carried out strong adjustments in the 1980s. For example, Sweden adjusted its overall budget balance by over 10 percent of GDP over a four-year period, and Greece adjusted by almost 12 percent of GDP over an eight-year period. Ireland, which adjusted its general government deficit from 8 percent of GDP to about 1½ percent of GDP during 1987-89, provides a useful example of a “contractionary expansion,” where fiscal tightening was accompanied by significant improvements in the country’s macroeconomic performance.1

Fiscal Consolidation in EU Countries

(In percent of GDP)

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Source: OECD.

Much of the fiscal adjustment was driven by substantial reductions in current primary spending, which contributed both to the sustainability of the adjustment and to the improvement of economic performance. Expenditure adjustments featured prominently not only in the high-spending Nordic countries (Denmark, Finland, and Sweden) and Ireland, but also in a number of other economies that had initially attempted to consolidate through higher taxes (e.g., Germany, Greece, Spain, France, Italy, and the Netherlands). Current primary expenditures were cut significantly in all but a handful of EU economies. Spain reduced primary spending by over 6½ percent of GDP during 1994-97, mainly through cuts in subsidies and transfers. Finland consolidated social security and welfare payments by 8 percent of GDP during the 1990s through reforms of the pension system and unemployment benefits. Schuknecht and Tanzi (2005) conclude that OECD countries that succeeded in substantially reducing public spending, also experienced significant recoveries in trend output and employment. Ardagna (2004) also highlights the role of expenditure-based adjustments in supporting growth.

More generally, mounting research evidence points to the key role that expenditure policies play in successful fiscal adjustments. Successful fiscal consolidations anywhere have commonly relied more heavily on restraining government spending than on increasing revenues; have implemented permanent measures rather than relied on expenditure suppression; have put more emphasis on cutting current spending (instead of capital spending); and in particular, have tackled key issues related to the government wage bill, subsidies, and transfers. Revenue-based consolidations have often been reversed, except when they have emphasized broadening the tax base and strengthening tax administration. Following large, expenditure-based fiscal adjustments, GDP growth has recovered to trend during the first two years of the adjustment, driven by private investment and gains in consumption and trade balances (Tsibouris and others, 2006).2

1Drummond, Jenkner, and Schwartz (2003).2 These results are in line with previous studies (e.g., Alesina and Perotti (1997); Alesina and Ardagna (1998); and Alesina, Perotti, and Tavares (1998)).

To increase the sustainability of fiscal adjustment and support growth, this trend needs to be reversed. In addition, there is considerable scope to modernize and better target the delivery of public services. The steps under consideration by the authorities go in the right direction, and the task is to rapidly establish supporting legislation and administrative procedures. However, bolder efforts are needed, particularly to redirect budget support to families to the poor, restructure higher education, phase out the housing subsidy scheme, and address the fiscal implications of an aging population by reforming the pension system. This subsection discusses expenditure reform options in the areas of health care, education, government employment and wages, pensions, social benefits, and subsidies (Table 2).9

Table 2.

Hungary: Menu of Reform Options and Potential Budgetary Savings

(Total in percent of GDP over 2006-10)

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Sources: Technical Assistance from the Fiscal Affairs Department; and staff estimates.

Based on discussions held during the 2006 Article IV Consultation. It does not reflect measures in the Convergence Programme presented in September 2006.

Health care

38. Hungary has a comprehensive insurance-type health care system, based on the principle of social solidarity. Compulsory contributions are paid according to earnings rather than individual health risks. Coverage is close to universal in terms of treatments provided, with virtually all citizens benefiting from the service irrespective of contributions. Still, the health status of the Hungarian population has remained poor by European standards.10

39. Health services are provided primarily through the Health Insurance Fund (HIF). The fund receives health care contributions from employers and employees, and deficits are covered by the state budget.11 The Fund is used to finance the majority of current spending on health care services and general subsidies on prescription drugs. Capital spending and certain other health expenditures (e.g., ambulance services and high-tech interventions) are funded directly by the budget. The fund is burdened with a mix of different expenditure responsibilities, some of an insurance nature and some of a social transfer nature. This setup reduces the transparency of the financing arrangements.

40. Although public health care spending is in the middle range among EU countries, it is relatively inefficient. Public spending on health care is about 5 percent of GDP, compared with an average of close to 6 percent in the EU. A comparison across EU countries suggests that there is significant scope to increase the efficiency of public spending on health care in Hungary (Figure 1). Formal copayments remain very limited, but there is widespread use of informal user charges. This is an inefficient way to provide medical services, encourages corruption, and limits access to poor segments of the population. Spending pressures for health care are expected to become more pronounced in coming years due to a combination of aging, rising incomes, and technological developments.

Figure 1.
Figure 1.

Selected European Countries: Efficiency of Public Health Spending, 1998-2002

Citation: IMF Staff Country Reports 2006, 367; 10.5089/9781451818048.002.A002

Source: Mattina and Gunnarson (2006).

41. High spending on pharmaceuticals remains an ongoing problem. Hungary spends about 1.5 percent of GDP on pharmaceuticals, accounting for more than 30 percent of total health expenditures. This places Hungary second in the OECD (OECD, 2005). Despite efforts to contain overruns, pharmaceutical subsidies are expected to once again exceed budget allocations in 2006.12

42. Several reforms have been introduced since the 1990s, but achievements so far have been mixed.13 Problems are particularly acute in hospital care, where the structure of incentives remains poor and progress to prevent uneconomic access to hospital services has been slow. There is virtually no competition among health care providers. Hospitals are largely owned and operated by local governments, which bear much of the responsibility for primary and secondary health care. Private institutions are limited to the provision of various specialized medical services.

43. Options to rationalize health care spending and increase the efficiency of the health system include the following:

  • Introducing a co-payment system for nonbasic health care services. To reduce risks from curtailing access to low-income families, co-payments should not apply to clearly cost-effective preventive services, a limit could be set on total household co-payments, and the lowest-income families could be exempted.14 Table 3 presents examples of cost-sharing arrangements in the health sector in selected countries.15

  • Separating health care activities from social insurance activities in the HIF. This would increase transparency.

  • Fostering hospital privatization and increasing efficiency in inpatient care. This would enhance competition and create a base for a better system of reference cost computation.16 Publicly owned hospitals should be legally organized as public benefit corporations or limited liability corporations and compete on a level playing field with privately owned hospitals.

  • Reforming pharmaceutical subsidies. Several actions would be advisable: (i) restricting the number of subsidized drugs and determining the specific drug(s) to be subsidized for each illness by periodic competitive tenders; (ii) reducing normative subsidization; (iii) putting family doctors in charge of issuing all prescriptions; and (iv) strengthening administrative procedures for limiting excessive drug prescription and consumption patterns.17

Table 3.

Exclusion from Coverage and Cost-Sharing in Selected Countries

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Sources: Cutler (2002), and Docteur and Oxley (2003).

Education

44. Hungary’s education system has undergone significant changes over the past decade. Participation rates in upper secondary and tertiary education have increased considerably; there has been a devolution of schooling decisions to the local level; and a significant number of university students now pay cost recovery fees. In 2001, several reforms to enhance the quality of education were introduced, including a new national framework curriculum, quality development systems for schools, a comprehensive evaluation scheme, and a teacher career model.

45. Public spending on education in Hungary is slightly above averages in the EU-15, with employment levels significantly higher. Public spending on education amounted to under 6 percent of GDP in 2004, close to the average in New Member States (NMS) and slightly above the average in the EU-15. Student-teacher ratios and mandatory teaching loads are significantly below international standards. Public spending on tertiary education is relatively high, both in per student and absolute terms, but the number of graduates has not increased accordingly compared with other countries (Figure 2). Finally, the structure of public higher education has lagged behind labor market developments, with low enrollment in the more practical curricula.

Figure 2.
Figure 2.

Selected Countries: Efficiency of Public Education Spending, 1998-2002

Citation: IMF Staff Country Reports 2006, 367; 10.5089/9781451818048.002.A002

Source: Mattina and Gunnarson (2006).

46. Options to modernize the education system include the following:

  • Reducing education employment. With student-teacher ratios significantly below OECD averages, reducing education sector employment is an important priority, especially given demographic trends.18 In addition, if mandatory teaching hours were aligned with international standards, there would be an even stronger need for staff adjustments.19

  • Merging small and underutilized schools to obtain economies of scale and efficiency gains in administration. Relatively low student performance in small districts indicates that the present model of quality assurance needs to be improved. In general, larger school districts have demonstrated a greater capacity to adjust to changing student numbers, resulting in more cost-effective school operations. Local governments are already being given financial incentives to form associations, but these have been insufficient to achieve results. In this sense, linking the normative grant financing formula to performance indicators could encourage more efficient management.20

  • Aligning the higher-education system more closely with labor market needs. Changing the characteristics of existing state-financed places to OECD averages in terms of duration and fields of study would significantly reduce outlays on tertiary education.21 Less emphasis should be put on expensive areas of studies (e.g., agricultural and science degrees) and study times should be shortened.

  • Increasing private contributions to higher education. Ideally, a moderate tuition fee should be introduced to reflect the private benefits to the individual of higher education. At the same time, student grants and housing benefits should be channeled to the truly needy.

Government employment and wages

47. Government wages and employment have been on the rise. In recent years, there have been substantial wage increases in the public sector, ranging between 15 and 55 percent (Table 4). Rising wages have been accompanied by rising employment levels until 2004, further aggravating the situation.22 As a result, the wage bill grew from 11 percent of GDP in 2001 to nearly 13 percent of GDP in 2005, and the average salary of public administration employees is estimated to be 25 percent higher than in the private sector.23

Table 4.

Hungary: Public Sector Pay Increases, 2001-03

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Source: OECD.

48. The high degree of decentralization seems to have generated inefficiencies. Large-scale decentralization in the early 1990s has resulted in a significant number of autonomous local governments. Of a total of 3,200 local governments, roughly half govern fewer than 1,000 inhabitants. Many of the smaller communities cannot meet minimum service standards because they lack qualified personnel.

49. Measures to achieve a long-lasting reduction in the size of government include the following:

  • Implementing a medium-term civil service reform. Wage freezes, hiring freezes, and employment cuts as proposed by the authorities could yield short-term budgetary savings.24 However, these measures should be seen as partial solutions. A civil service reform should be integrated into a medium-term strategy that aims to achieve a sustained reduction in the wage bill. The sequencing of the reforms is particularly important, and the following principles apply: (i) civil censuses and functional reviews should precede the design of retrenchment programs; and (ii) the monetization of benefits should precede the reform of pay structures.

  • Abolishing various allowances and bonuses, and monetizing the bonuses that are retained. Several noncash benefits, for instance, for meals and transportation, have little economic justification and are generally not related to merit.25 Also, extending performance-related pay to the entire public service would be advisable.

  • Providing incentives for intergovernmental cooperation and privatization in local service delivery. Budget constraints should be tightened and fiscal responsibility increased. This could be achieved, for instance, by introducing penalties for local governments that are not able to provide services due to lack of cooperation. As noted in Section B, strengthening local revenue sources is an urgent priority and would improve accountability.

Pensions

50. Hungary faces important pressures stemming from age-related expenditures. Hungary is among the NMS that will face the most significant increases in age-related expenditures in the coming decades (Table 5 and Figure 3). Particularly acute will be pressures stemming from pension benefits, which are expected to rise from about 11 percent of GDP in 2005 to 15 percent of GDP by 2035.

Table 5.

Age-Related Expenditures in NMS, 2005-50

(In percent of GDP)

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Source: Standard and Poor’s.
Figure 3.
Figure 3.

Hungary: Age-Related Expenditures, 2005-50

(In percent of GDP)

Citation: IMF Staff Country Reports 2006, 367; 10.5089/9781451818048.002.A002

Source: Standard and Poor’s.

51. Reforms in the late 1990s sought to improve the sustainability of the pension system, but more recent changes have reversed some of the benefits. A major overhaul of the pension system was implemented in 1998, introducing both parametric and paradigmatic changes. A critical component of the reform was the creation of second-pillar mandatory pension funds.26 The parametric changes helped contain pension expenditures in the short run and reduced long-term liabilities. However, following the reform, employer contributions were reduced during 1998-2002. This reduction was not accompanied by a tightening of benefits. On the contrary, a 13-month pension was introduced in 2003.27 As a result, and despite the reform, the Pension Insurance Fund continued to post deficits of around 2 percent of GDP. Orbán and Palotai (2005) estimate that net implicit liabilities (NIPs) of the pension system were around 60 percent of 2004 GDP in 1998. The cuts in social security contributions up to 2002 increased NIPs to 150 percent of GDP, while the 13-month pension led to a further deterioration to nearly 200 percent of GDP.28

52. Despite some improvements, the effective retirement age remains low, and the current indexation formula for pension benefits is fairly generous. One of the most important changes in the 1998 reform was the gradual increase in the statutory retirement age.29 However, early retirement is possible, and data on effective retirement age suggest that most individuals, especially males, take advantage of this opportunity. 30 The 1998 reform also replaced wage indexation by “Swiss” indexation of pension benefits (combining wages and prices). This formula still allows pensioners to participate in productivity gains that are passed on to real wages and is more costly than alternative options used elsewhere in Europe.

53. Eligibility criteria for disability pensions remain lax. A disability pension can be obtained by those who have lost at least 67 percent of their working capacity due to damage to their health or as a result of reduced physical or mental abilities. Disability benefits have often been used to finance premature labor market withdrawal and as a substitute for unemployment insurance. The fastest-growing group of disability pensioners is composed of workers between 46 and 60 years of age, and the regional distribution of beneficiaries shows a strong correlation with regional unemployment rates.

54. Options to place the pension system on better financial footing include the following:

  • Introducing further parametric changes in the pay-as-you-go system. In particular, (i) replacing the Swiss indexation formula for pension benefits by price indexation; (ii) raising the early retirement age until early retirement provisions have been eliminated; and (iii) phasing out the 13-month pension. These actions would not only generate savings to the budget in the short run but also enhance the long-term sustainability of the pension system.31

  • Implementing a system of notional defined contributions (NDCs), without altering the pay-as-you-go nature of the first pillar of the reformed system. NDCs link individual future pension entitlements with individual contributions paid into the system.32 This system would prevent manipulation of pension benefits, encourage later retirement, and greatly enhance transparency. The extent to which NDCs improve fiscal sustainability would depend on the design of the system.33

  • Tightening eligibility criteria for disability pensions. Specific measures include increasing the number of referrals to vocational rehabilitation programs provided by the public employment service; emphasizing “inability to work” rather than “damage to health” as the key criterion for granting disability pensions; and reexamining disability benefits granted for those under 40 years of age.34

Social transfers

55. Hungary maintains a comprehensive and complex system of social protection. Apart from social insurance and unemployment benefits, the central and local governments administer a wide array of social cash transfers (family allowance, pregnancy and maternity benefits, child care benefits, and several others). In general, locally administered benefits are means tested,35 while the central government mostly allocates universal family benefits. The administration of social benefits is fragmented, with many overlapping institutions involved.

56. Contrary to international trends, the system is moving away from greater targeting and is becoming more generous. Means testing for family benefits has been eliminated and most of the general budget support to families is offered as an entitlement, granted to everyone as a family allowance based solely on the number of children.

57. Improving the targeting of social transfers could yield budgetary savings while redirecting support to those most in need. In particular, the following measures could be considered:

  • Abolishing the tax deduction for children and introducing means testing for the family allowance.36 These measures would not increase poverty. While it can be argued that family benefits are to some extent self-targeting due to the high correlation between poverty and the number of children, the tax deduction is regressive: only those who pay taxes can benefit from the deduction, and minimum wages became tax-exempt in 2002. Abolishing the family allowance for the top two income quintiles would generate savings to the budget while protecting the poorest segments of the population.37

  • Streamlining and simplifying benefits through a unified administration of welfare services. A unified social need benefit could be introduced, aimed at supplementing household income to reach minimum living standards, defined according to the age profile and size of the household. While this reform would require frequent household budget surveys and in-depth poverty analyses, issues of means testing could be alleviated by compiling a central database. A single institution with decentralized branches could be assigned the administration of welfare benefits.

Government subsidies

58. Explicit and implicit subsidies have remained fairly pervasive. The government maintains major explicit subsidies in support of pharmaceutical prices, agriculture, housing, and transportation. In addition, it maintains implicit subsidies in some of the very same areas (e.g., transportation), as well as for public utilities, mainly through the maintenance of low end-user prices. While the overall incidence of the various subsidies is unclear, large-scale subsidy operations for a wide range of activities suggests the scope for efficiency gains can be significant.

59. There is a strong need to rationalize government subsidies, improve targeting, and enhance transparency.38 The following would be steps in this direction:

  • Reforming housing subsidies. Important measures would include consolidating various housing support mechanisms and reevaluating their overall size; limiting government exposure to financial risks under the two mortgage subsidy schemes; and reevaluating the size of housing-related support to local governments.39

  • Reforming transport subsidies and state support to state-owned enterprises. This would require introducing cost recovery fares, on the basis of which subsidies could be provided to specific population groups. At a minimum, incentives for overconsumption should be curtailed by requiring all passengers to pay fares, even at highly subsidized rates. Providing lump-sum nominal subsidies (not linked to the ticket price) would insulate the state budget from fare increases. Structural reforms of state-owned transport companies would limit capital transfer needs in the future.40

  • Reforming electricity and gas price subsidies. Gradually increasing electricity tariffs and natural gas prices could produce important budgetary savings. These measures should be accompanied by targeted assistance to vulnerable households.41

Creating a more equitable and efficient tax system

60. Hungary has a modern tax system and an effective tax administration. The country has made important progress in improving its tax system and tax administration over the last years, relying on the three pillars of the income tax, the value-added tax (VAT) complemented by excises, and social security contributions. In the process of accession to the EU, Hungary adjusted its tax legislation to comply with the acquis communitaire, for instance by clearing the corporate income tax of tax privileges for offshore companies, increasing the VAT rate on certain goods to the minimum EU level of 15 percent, and transforming zero rating under the VAT into a lower rate of 5 percent (except for exports). The tax authority (APEH) has reached a high level of development when compared to tax administrations in peer countries.

61. Nevertheless, problems in both tax policy and tax administration have developed recently. The tax revenue-to-GDP ratio has followed a downward trend in recent years. Particularly worrisome is the continuing deterioration in VAT performance. The dismantling of border controls and adoption of self-assessment procedures following accession in 2004 seem to have exacerbated existing administrative problems.42 In the area of tax policy, the package approved in 2005 was conceived to quickly grant tax relief without regard for the integrity of the tax system and the macrofiscal framework (Box 2).

Main Features of the Tax Package Approved at End-2005

  • Value added tax. The standard rate was reduced from 25 percent to 20 percent on January 1, 2006.

  • Personal income tax. The higher rate was reduced from 38 to 36 from on July 1, 2006.

  • Capital income and gains will be taxable at 10 percent from 2007 onward (18 percent from 2010).

  • The corporate income tax will be reduced to 10 percent for the first Ft 5 million under certain conditions.

  • The tax rate on dividends sourced in the EU will be reduced from 25 to 10 percent in 2007.

  • The municipal business tax will be eliminated in January 2008.

  • A luxury tax was introduced in January 2006.

  • Employers’ contributions to social security will be reduced gradually by 7 percentage points by 2009.

  • The 4 percent individual contribution to health security will be levied from 2006 onward, also on part-time jobs and certain benefits of corporate managers.

62. The authorities’ tax strategy under the new adjustment package raises concerns. Hungary’s tax burden is heavy, especially when its level of development is controlled for (Figure 4). The tax wedge, and particularly social security contributions, exceeds the average in the euro area and in neighbor countries, and is significantly above levels in other emerging market economies (Table 6). As noted above, the authorities’ fiscal package relies heavily on tax increases, particularly related to labor and capital.43 However, this strategy may not deliver the anticipated revenues, as it may burden the tax administration44 and undermine growth potential and competitiveness.45 Fiscal consolidation efforts would, in that case, be thwarted, requiring the authorities to undo the tax increases without having found a permanent solution for stabilizing the public finances.

Figure 4.
Figure 4.

Selected Countries: Tax Burden, 2003

Citation: IMF Staff Country Reports 2006, 367; 10.5089/9781451818048.002.A002

Sources: IMF, World Economic Outlook; OECD; World Bank, World Development Indicators; IMF, Government Finance Statistics; and IMF, Database on Emerging Market Economies.
Table 6.

Selected Countries: Tax Wedge, 2003

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Source: OECD.

Single person without children at 100 percent of average earnings.

63. Because fiscal consolidation needs are so large, revenues have to be increased, but the opportunity should be used to achieve a more stable and equitable tax system. While a significant share of fiscal adjustment should rely on expenditure consolidation, revenue measures will be essential to reverse the expected decline in tax collection in the coming years. In this sense, putting on hold even the desirable elements of the 2005 tax reform seems unavoidable. At the same time, efforts to raise additional revenues should focus on creating a more equitable and efficient tax system.

64. The following measures would be steps in that direction:46

  • Eliminating tax exemptions. Countries that have implemented successful revenue-based fiscal adjustment have generally relied on broadening the tax base by phasing out exemptions and strengthening tax administration. In Hungary, several exemptions and deductions apply under both the PIT and CIT.47 Eliminating some of these exemptions would not only bring budgetary savings but also create a simpler tax system, thereby promoting the sustainability of the adjustment.

  • Strengthening the real estate property tax. The real estate tax should provide an independent source of revenue for municipalities, since the local business tax is to be abolished in 2008.48 Own-source revenues for local governments are essential for accountability and could reduce dependency on transfers from the central government.

  • Taxing pension benefits under the personal income tax (PIT). Contrary to the current practice in most countries, pension benefits are not subject to income taxes in Hungary. At the same time, contributions to pension schemes are deductible from the PIT when contributed by individuals and deductible as operating costs of employer enterprises under the corporate income tax (CIT). This complete exclusion of pension benefits in the formation and use of pension resources lacks justification.

  • Taxing interest income and capital gains. The combined taxation of entrepreneurial activity—comprising the CIT and the PIT on distributed dividends—is excessive when compared with the taxation of fixed capital income. Adoption of this measure would rebalance income taxation. To facilitate implementation, no exemption threshold should be introduced on the withholding tax on interest paid by financial institutions.49

  • Increasing the intermediate VAT rate from 15 to 20 percent. This would partially compensate for the decline in VAT revenues stemming from the 2005 reform. In addition, simplifying the rate structure could be beneficial administratively.

65. Revenue mobilization will need to be accompanied by efforts to strengthen tax administration.50 As noted, APEH has reached a high level of development when compared to tax administrations in peer countries and has adopted many practices used by effective tax administrations around the world. However, the changing post-EU accession environment is posing new challenges that need to be addressed.

66. In the short term, measures should aim to protect the VAT revenue base and strengthen the enforcement of tax arrears. This involves (i) setting up revenue targets agreed by the Ministry of Finance and APEH and a mechanism to reward good performance, in order to provide incentives for APEH to accurately forecast and achieve targets; (ii) reallocating resources from routine checks to audits in areas where the risk of noncompliance is highest (such as the VAT); (iii) strengthening the authorities’ legal capacity to recover tax arrears; (iv) introducing expedited procedures for appeals and assessments in case of failure to submit a tax return; and (v) implementing a more agile and secure handling of VAT refunds.51

67. In the medium term, APEH should adopt a modernization strategy. Some of the key elements of such a strategy would include (i) reducing APEH’s responsibilities for performing nontax functions; (ii) restructuring its organizational structure; (iii) removing from the law all provisions that mandate the auditing of specific categories of taxpayers; (iv) simplifying administrative procedures, promoting electronic filing of tax returns, and improving taxpayer services; (v) making greater use of risk-based techniques for the audit and collection of tax arrears; and (vi) setting up dedicated teams to focus on the “shadow economy” and to investigate criminal violations of tax laws.

Strengthening fiscal transparency and accountability52

68. Fiscal slippages will continue unless fiscal transparency, accountability, and budget controls are strengthened. Persistent deficit overruns have become characteristic in Hungary, with the projected 2006 excess a new record high. Reestablishing fiscal credibility is, therefore, an important priority. And while the country complies with many requirements of the IMF Code of Good Practices on Fiscal Transparency, creative accounting and other adjustments in fiscal data in recent years have complicated policy analysis and weakened transparency in many areas. These have included, for instance, (i) changes in the schedule of wage payments and VAT reimbursements; (ii) off-budget motorway investments;53 (iii) the impact of pension reform;54(iv) one-off balance sheet operations from nonbudget entities;55 and (v) adjustments for military spending.56

69. Key areas for improving fiscal transparency and accountability include the following:

  • Adopting the ESA 95 basis for the budget and undertaking quarterly reviews. Given that Hungary’s Convergence Program for euro adoption is framed in terms of ESA 95, and this is the key statement of the government’s medium-term fiscal policy objectives, the internal fiscal policy debate should ideally be based on ESA 95 concepts. The budget documents and financial statements should therefore shift to an ESA 95 basis in terms of coverage, and gradually adopt its accounting principles and practices. To aid monitoring of fiscal policy implementation, and to ensure timely and appropriate responses when fiscal policy goes off track, the government should undertake quarterly reviews on an ESA 95 basis.

  • Developing a three-year rolling budgetary framework with expenditure ceilings. Given the need for fiscal adjustment to focus primarily on expenditure reforms, the medium-term budget framework could take the specific form of multiyear expenditure targets. These would anchor the adjustment effort, guide the formulation and implementation of structural measures, and sustain fiscal discipline while allowing automatic stabilizers to operate on the revenue side. Stronger budgetary controls are also needed to curtail expenditure overruns, including by imposing limits on expenditures financed by carryover funds and by discontinuing the practice of allowing additional expenditures without appropriations and parliamentary approval.

  • Improving fiscal risk analysis. Fiscal risks are pervasive and need to be fully taken into account when formulating fiscal policy. A supplementary report to the budget should identify and quantify to the extent possible different sources of fiscal risk.57 Special attention needs to be paid to PPPs, in general because of the hidden costs that long-term contracts can entail, and more specifically because the desire to keep PPPs off budget can transfer risk to private partners at excessive cost to the government. Fiscal risk analysis should also look at other factors affecting fiscal outcomes, such as uncertainty on short-term macroeconomic forecasts and medium-term projections, including to take into account the implications of an aging population.

  • Strengthening independent scrutiny of fiscal policy. An independent body that reports to parliament and reviews the time consistency and transparency of budgets would strengthen transparency and accountability. Needed in this context is an assessment of the budget quality and risks, and a requirement of a response to that assessment before parliamentary approval of the budget. One option is to strengthen the mandate of the State Audit Office. An alternative would be to set up an expert council with a mandate to provide an independent view on fiscal policy.

  • Moving toward the implementation of performance budgeting. Budgeting decisions should be based on better information about the benefits of alternative expenditure options. This is an area where little progress has been made. Advancing the implementation of performance budgeting requires the following: clearly specifying the objectives of public expenditure in terms of intended outcomes; classifying expenditure in terms of objectives; developing performance indicators, program evaluation, and other methods of obtaining information about program performance; and modifying the budget process to give greater attention to choices about the best allocation of limited resources between competing purposes.

D. Concluding Remarks

70. Placing public finances on a sound footing is an urgent priority. By quickly proposing sizable fiscal measures, the government has acknowledged the urgency of containing growing public indebtedness and macroeconomic imbalances. However, a more ambitious and better-quality fiscal consolidation is needed to reduce vulnerabilities, thereby allowing euro entry from a position of strength. A stronger focus on expenditure reforms, including to improve targeting and efficiency, will achieve sustainable consolidation and support long-term growth potential. Revenue measures are also required, but this opportunity should be used to create a more stable and equitable tax system, including by broadening the tax base and strengthening tax administration. An ad hoc strategy to raise the already high taxes on labor and capital could undermine the sustainability of the adjustment and be detrimental to growth and competitiveness. Fiscal consolidation efforts should be supported by stronger budget controls and greater transparency and accountability to stem the endemic fiscal slippages of recent years.

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5

Prepared by Ana Corbacho (FAD) on the basis of discussions held during the 2006 Article IV consultation. The paper therefore does not reflect information contained the Convergence Programme presented in September 2006.

6

The deficit figures throughout the paper include the costs of the pension reform (about 1.5 percent of GDP in 2006) and the aircraft lease (0.3 percent of GDP in 2006). If recent public-private partnerships (PPPs) are treated on budget, in line with the ROSC recommendations, the 2006 deficit would rise by 0.6 percent of GDP. See Section C for further details.

7

See the second subsection of C for further details on the 2005 tax reform.

8

See IMF (2006a) for further details on debt sustainability analysis under the authorities’ scenario, staff’s baseline scenario, and staff’s proposed scenario

9

This section draws from Technical Assistance (TA) provided by the Fiscal Affairs Department (FAD).

10

Until recently, the life expectancy of men had remained unchanged since the 1960s, and the life expectancy of women, while rising, is still relatively low. (OECD, 2001).

11

Fund deficits have been fluctuating at around 1½ percent of GDP in recent years.

12

In 2004, the government negotiated a two-year agreement with producers. A 5 percent maximum annual increment in the state budget for financing pharmaceutical expenses was defined for 2005 and 2006. Any medicine expense above the given level is supposed to be paid jointly by the state and the producers according to a risk-sharing scheme involving a regressive government contribution.

13

See Goglio (2005) for further details.

14

Potential savings from introducing co-payments vary depending on their design. As a first step, co-payments could be introduced for services that are clearly nonbasic (e.g., spa treatments). A more generalized co-payment system on all specialist visits and in-kind services could be based on a lump sum. Eventually, the co-payment system could consist of a cost-sharing price, with the share varying typically between 10 and 30 percent.

15

In the Slovak Republic, the introduction of co-payments seems to have eliminated surplus demand for medical services with only a negligible impact on availability (Pažitný, Zajac, and Marcincin, 2003).

16

CEMI (2006) estimate savings of 0.2 percent of GDP from the reform of inpatient care.

17

Several of the actions mentioned aim at improving incentives to use cheaper generic drugs and restrict excessive consumption of drugs. However, the most direct way to achieve savings on pharmaceutical subsidies is to reduce the normative subsidization rates. At a minimum, co-payments for fully subsidized drugs should be introduced (except for patients who receive free drugs due to social reasons).

18

The number of full-time students in primary education has decreased by about 300,000 since the beginning of the 1990s, while the number of teachers has decreased by less than 10,000. As a result, the student-teacher ratio in elementary school went from an already low 12.2 in 1990 to 10.2 in 2005 (Ministry of Education, 2005).

19

As an example, having student-teacher ratios at around OECD averages (about 30 percent higher) would reduce the wage bill by roughly 0.4 percent of GDP (FAD TA). CEMI (2006) estimates that reducing education employment by about 40,000 staff would yield savings of about 0.4 percent of GDP by 2010.

20

The grant scheme could be linked to performance indicators, such as student-teacher ratios, student-classroom ratios, student performance, etc. In some countries, for instance, the wage norm takes into account average class size and average number of hours taught, allowing schools to pay higher wages and attract more qualified personnel as long as they decrease employment and increase the workload of teachers. CEMI (2006) estimates savings of about 0.2 percent of GDP from merging schools in towns and the city of Budapest.

21

FAD TA estimated savings of around 0.4 percent of GDP.

22

Hungary’s public employment accounts for over 20 percent of total employment, one of the highest ratios in the OECD.

23

CEMI (2006).

24

The authorities estimate that a two-year wage freeze, coupled with a targeted reduction in employment, could yield about 0.7 percent of GDP in budgetary savings by 2008. CEMI (2006) estimates that sizing down public administration employment by 50,000 staff could yield 0.4 to 0.6 percent of GDP in budgetary savings by 2010, while a wage freeze could save 0.8-1 percent of GDP over the same period.

25

Eliminating these payments could save 0.2 percent of GDP (FAD TA).

26

Impavido and Rocha (2006) conclude that the second pillar has had a mixed performance since its introduction in 1998.

27

The 13-month pension increased the effective replacement rate, further encouraging early retirement and weakening incentives to remain in the labor market.

28

Estimates based on a real discount rate of 3 percent.

29

The reform of 1998 raised the statutory retirement age for men from 60 to 62 years; for women the retirement rate is rising from 57 to 62 years in 2009. However, effective retirement ages are close to 60 for men and 58 for women.

30

Orban and Palotai (2005).

31

Potential savings could amount to under 2 percent of GDP in the short run. Due to compounding effects, savings would grow over time.

32

This has been implemented by several countries, including Sweden and Poland.

33

See Holzman and Palmer (2006) for a description of issues and country studies.

34

FAD TA estimates savings of about 0.2 percent of GDP, somewhat lower than those in CEMI (2006).

35

Local governments receive normative grants from the central government to cover a large part of their expenses.

36

These measures could generate 0.6 percent of GDP in savings (FAD TA).

37

Still, problems related to identifying true income levels, given that tax returns are often a poor measure of income, would need to be resolved. To restore some progessivity, uniform family benefits could at least take the form of refundable tax credits, replacing the combination of tax deductions and cash benefits, these credits could be paid out in cash to those families that do not pay taxes.

38

See subsection on health care for details on pharmaceutical subsidy reform.

39

These measures could reduce subsidy amounts by 0.2 percent of GDP (FAD TA).

40

Budgetary savings could amount to 0.5 percent of GDP. As noted by IMF (2006b), the railways and the Budapest Transport Company undertake, on behalf of the government, quasi-fiscal activities that are not governed by transparent arrangements. There is scope for further savings depending on the nature and depth of the reform of these companies, which have relied on budget support to cover operating losses.

41

The authorities’ program incorporates savings of about 1 percent of GDP from the reform of gas and electricity subsidies. The schedule of price increases beyond 2007 has yet to be defined. Staff savings’ estimates are more modest (Table 2).

42

Initially, the authorities had also adopted self-assessment procedures for imports from third countries. Subsequently, in part due to concerns about possibly increasing fraudulent behavior, they have reinstated the payment of VAT and excises on imports at the border for most of the third countries.

43

See IMF (2006a) for further details on the authorities’ tax package.

44

The tax administration is considering changing the jurisdictional structure, from counties to regions, and the effectiveness of tax collection could suffer during the transition. Frequent changes in the tax code would be difficult to implement and enforce. In contrast, efforts should focus on improving VAT compliance.

45

For instance, the World Bank (2006) reports that a wider tax wedge tends to be associated with lower employment in the EU-8, which, in turn, is associated with lower per capita income. Using a panel of OECD countries, Ardagna (2004) stresses that the impact of fiscal adjustment on growth depends largely on the composition of the adjustment and its bearing on the labor market: reductions in public employment and wages are associated with higher growth rates, while increases in labor taxes have the opposite effect.

46

Several of these measures are under consideration in the authorities’ program. Staff estimates of their yield are presented in Table 2

47

These include, for instance, tax credits for small and medium-sized enterprises, development projects, and small investments, as well as exemptions for pension contributions, minimum wages, insurance premiums, and purchases of computer equipment. The cost of these exemptions and deductions can be roughly estimated at over 3 percent of GDP.

48

The local business tax amounts to 1½ percent of GDP, while the real estate property tax currently yields only 0.3 percent of GDP.

49

Such withholding should be final; alternatively, individuals could be given the option to consider the tax as final or as an advance payment creditable against their annual (interest-inclusive) income tax.

50

This section draws from TA provided by FAD.

51

This would involve, for instance, broadening VAT audit coverage and accelerating audit techniques; allowing APEH to suspend the timetable for paying VAT refunds under certain conditions; strengthening powers to legally enforce central assessments when returns are filed late; and speeding up processes to remove from the VAT register businesses that have no genuine economic activity.

52

This section draws from IMF (2006b).

53

Following Eurostat’s decision to disallow revenues from the sale of existing motorways to the state-owned enterprise, AAK (under an alleged PPP), the 2005 fiscal deficit was revised upward by almost 2 percent of GDP. IMF (2006b) concluded that government ownership of motorways, irrespective of who builds them, implies that this investment should be recorded on budget. On budget classification of these expenditures would increase the fiscal deficit by 0.6 percent of GDP in 2006, 0.9 percent of GDP in 2007, and 0.1 percent of GDP in 2008.

54

In September 2004, Eurostat temporarily allowed Hungary and other EU member states to calculate fiscal balances excluding the cost of pension reform from compulsory funded pension schemes. This treatment has lowered fiscal balances since 2000 but will be discontinued in a few years. The impact amounted to about 1½ percent of GDP in 2006.

55

These relate primarily to the assumption of debt from railways and other nonbudget entities that perform quasi-fiscal activities but do not receive sufficient budget support to cover operating losses.

56

A recent Eurostat decision on the classification of the expenditure of a recently acquired military aircraft has moved about 0.3 percent of GDP back to the budget.

57

Sources of fiscal risk include guarantees and other contingent liabilities that may end up adding to government spending and debt, quasi-fiscal activities that undermine the financial position of state-owned enterprises necessitating bailouts, and tax expenditures that weaken the tax base. At present, Hungary reports only guarantees in a transparent fashion.

Hungary: Selected Issues
Author: International Monetary Fund