Selected Issues


Selected Issues

The Grey Economy and Tax Compliance1

This chapter describes Hungary’s key policy initiatives to enhance tax compliance and reduce the grey economy. Hungary has embarked on a comprehensive strategy to shift segments of the grey economy to the formal sector and improve tax compliance, which has already yielded sizeable gains in terms of VAT revenue. The strategy involved, among other elements, implementation of online cash registers and an electronic system monitoring the road transport of goods movement. Even though impressive efforts have been made, mobilizing additional VAT collection would lower vulnerabilities further. Specifically, simulations suggest that eliminating the VAT gap would reduce the overall deficit by around 2 percentage points and public debt by around 8 percentage points, thus reducing exposure to shocks and creating fiscal space for other initiatives. Beyond increasing tax revenue, moving more of the grey economy to the formal sector has various benefits in terms of increasing access to finance, productivity, and competitiveness.

A. Introduction

1. The reduction in Hungary’s grey economy coincided with improvement in the tax compliance. Estimates of the size of the grey economy suggest that it declined markedly in recent years, but its level remains above the EU average (Schneider, 2016). In parallel, the improvement in tax compliance has been significant although, similarly to the grey economy, its size is also above the EU average (European Commission, 2016).

2. Addressing the tax compliance challenge and reducing the size of the grey economy can be mutually-reinforcing. High tax rates and wedge have been incentives for looser tax compliance and for unregistered activities to remain in the grey economy. By the same token, simplifying the tax system and strengthening enforcement of compliance would help incentivize a shift to the formal sector. Increasing tax compliance would of course also contribute to improving the fiscal balance and reducing public debt, thus lowering Hungary’s vulnerabilities. Although Hungary has been able to reduce its budget deficit from a high level, its public debt is still large, at above 70 percent of GDP.

3. This chapter describes Hungary’s key policy initiatives to enhance tax compliance and reduce the grey economy. Section B defines the concept of the grey economy, presents its main determinants and impact, and looks at Hungary’s experience with it. Section C provides a rationale for further VAT revenue mobilization, documents key reforms underpinning the improvement in tax compliance, and presents recent VAT performance. It also runs policy simulations assuming the elimination of the tax compliance gap. Section D concludes.

B. The Grey Economy

4. The definition of the grey economy can be broad. One commonly used such definition is that it comprises unregistered economic activity that could contribute to the official GDP calculation. A narrower definition of the grey economy, which is used in this note, is that it comprises legal activities, such as undeclared work and underreporting, that are performed outside the reach of legal authorities. Specifically, these are all economic activities that would be legal and generally taxable if they were reported.2

5. Several factors can lead to a large grey economy. 3 High tax and social security contribution burdens can provide an incentive to operate in the grey economy. This tends to be particularly the case when salaries in the informal sector are relatively low and minimum wages in the formal sector do not match productivity. The quality of public institutions is another factor determining the size of the grey economy. Specifically, the informal sector tends to be associated with the inefficient provision of public goods and services as well as with bureaucracies that complicate doing business and breed corruption. Excessive regulations lead to high costs in the formal economy. At the same time, the quality public services may be affected by the existence of a large grey economy that does not pay taxes. Such a large grey economy would also mean higher taxes for firms and individuals in the formal sector.4 Thus, a vicious circle can be formed, with yet stronger incentives for more firms to stay in the informal sector. Low tax morale and certain social norms may increase the probability of individuals participating in the grey economy. When the grey economy is perceived to be a normal part of society, there is a lack of guilt conscience associated with not registering or paying taxes. Furthermore, when the penalties and/or the chance of getting caught are low, individuals would be more likely to take the risk. The lack of financial development can also contribute to a larger grey economy as cash transactions are typically difficult to trace.

6. The existence of a grey economy poses several challenges for policymakers. The grey economy would lead to forgone revenue due to the under-reporting of wages and unregistered business activity. Subsequently, such under-reporting could have a negative effect on access to credit from the banking sector. In addition, the undeclared activity could lead to lower quality output as well as working conditions due to the lack of proper regulation or worker and consumer protection. The grey economy also distorts statistical data, and therefore misleads economic policy making.

7. At the same time, there can be some benefits from the presence of the grey economy. Informal activities can act as a safety net by providing employment and income to people who are otherwise not able to find opportunities in the formal sector. Furthermore, with the existence of a grey economy, certain goods and services may be cheaper and thus more accessible to a larger share of the population. The grey economy may also provide an opportunity for existence to micro and small firms that would otherwise struggle due to the high cost and demand on time driven by heavy regulation. In fact, some economists argue that the informal sector plays a key role in facilitating economic activity when regulations are prohibitively excessive.

8. The Hungarian grey economy remains sizeable, with the high indirect taxes reported to be a key motivator. According to some estimates (Schneider, 2015), the grey economy in Hungary is equivalent to about 22 percent of GDP. This is larger than the EU average (18 percent), but is in line with the situation in regional peers. The above estimate is reached using a methodology which assumed that the grey economy can be estimated using measurable causes of illicit employment (e.g. the tax burden and regulation intensity) as well as indicators reflecting the illicit activities (e.g. the currency demand).5 The most important factor identified as contributing to grey economy in the case of Hungary is indirect taxes.


Grey Economy Estimates in Hungary

(in percent of GDP)

Citation: IMF Staff Country Reports 2017, 124; 10.5089/9781484300473.002.A002

Sources: Schneider, 2015

Grey Economy Estimates in Selected European Countries, 2015

(Percent of GDP)

Citation: IMF Staff Country Reports 2017, 124; 10.5089/9781484300473.002.A002

Sources: Schneider, 2015

9. The probability of getting caught and low tax morale are also identified as important determinants of the size of the Hungarian grey economy. For example, Balog (2015) points out that, until 2010, the tax burden on labor income in Hungary was quite high compared to the region. The marginal tax wedge was a high 64 percent, which provided incentives both to employees and employers to underreport wages. Similarly, in the case of consumption taxes, buying products or services from the grey economy, without an invoice, is sometimes reported as being considered an acceptable practice because of the lower cost. Consequently, Lacko (2007) argues that the grey economy is determined by the consumption tax rate and the level of corruption. The empirical results of Toth et al (2015) illustrate that an improvement in the tax morale can curb tax evasion. Such an improvement can stem from a reduction of unemployment or and enhancement of the quality of public services. These improvements can be supplemented by an effort to tighten monitoring and increase the cost of evasion, such as increasing the frequency of audits and their precision, publishing the names of payers in arrears, etc.

C. Tax Compliance

10. VAT is the largest source of tax revenue item in Hungary. VAT revenue amounts to almost 10 percent of GDP. This is comparable with regional peers. VAT is considered one of the least distortive taxes because it does not discourage savings, work, or investment decisions, especially compared to income taxes. With high domestic consumption (and imports), the potential gains from mobilizing VAT revenue are significant.


Tax revenue [in percent of GDP]

Citation: IMF Staff Country Reports 2017, 124; 10.5089/9781484300473.002.A002

Source: OECD

11. However, Hungary’s VAT rates are already high. These rates were increased markedly in the midst of the global financial crisis to mobilize revenue to cope with the large budget deficit. As a result, the standard VAT rate is now 27 percent, which is very high compared to the OECD average and is the highest among regional peers. The effective rate is, however, lower due to the introduction of reduced rates for selected items.6

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Source: OECD

12. There is potential for Hungary to mobilize additional VAT collection through enhanced tax compliance. Drawing on IMF (2016) and OECD (2015), the relative assessment of Hungary’s overall tax administration compared to other countries of the Central Eastern and South Eastern European (CESEE) region is strong. Hungary exceled in such aspects of tax administration as organizational structure, strategic management, operational performance, and IT/online services. This positive situation stems from reforms undertaken by the Hungarian authorities since the 1990s and which have been renewed following the eruption of the global financial crisis, especially in terms of enforcement. 7


Relative Strength of Tax Administrations in CESEE Economies

Citation: IMF Staff Country Reports 2017, 124; 10.5089/9781484300473.002.A002

Source: IMF (2016) and OECD (2015)

13. The Hungarian authorities have embarked on a comprehensive strategy to improve VAT compliance following the global financial crisis. An initial step of the strategy was to move all tax and customs administration activities to one organization. The National Tax and Customs Administration (NTCA) was created in 2011 by the merger of the Hungarian Tax and Financial Control Administration and the Hungarian Customs and Finance Guard. An important and integral element of the administration has been the General Criminal Directorate, which is a central agency operating with great autonomy, with more resources directed there. It performs fiscal investigative tasks as well as investigations with respect to crimes endangering the revenue of the budget and the violations of law related to intellectual property. The financial investigators perform their work in cooperation with professional staff in fields of taxation, customs, and excise. Unifying tax and customs administrations along with the strengthening of the Criminal Directorate has coincided with higher loss recovery rate and secured value by coercive measures. Furthermore, the tax registration procedure and the regulatory supervision were enhanced in 2012.

14. The implementation and execution of the enhanced tax registration procedure was also an important preventive measure. The enhanced procedure aimed at reducing the risk of registering firms that do not intend to conduct any real business activity and are used to engage in fraud, especially VAT carousel and refunds. Since its introduction in 2012, around 90 percent of registrations have been identified as having no impediments, but in around 5 percent of the cases the tax authorities have denied the request for the registration, and in around 5 percent of the cases the tax authorities have deregistered tax payers (NTCA, 2017).

15. The introduction of the online cash registers has been a critical element of the strategy. The electronic connection of cash registers to the tax authorities has been implemented to monitor the turnover of the cash registers on a real-time basis, helping detect fraud more efficiently. The number of cash registers connected to the tax authorities reached around 250 thousand by the end of 2016, although only selected activities have so far been covered by this program (MfNE, 2016).

16. The implementation of the Electronic Trade and Transport Control System (EKAER) in 2015 has been another important element of the strategy. The EKAER was set up in an effort to curb VAT fraud, enabling the monitoring of the road transport of goods movement. The purpose of the system is the strengthening of law-abiding businesses, assurance of the transparency of goods traffic, the exclusion of frauds with food that often jeopardize human health, and screening tax evaders. In case of irregularities, a default penalty up to 40 percent of the value of goods of uncertified origin can be imposed. Since its introduction in 2015, more than 60 thousand taxpayers and around 6.5 thousand transporters have registered on the interface of EKAER, accounting for more than 60 percent of domestic registrations (NTCA, 2017).

17. Other relevant measures are reducing the threshold for VAT and increasing VAT returns reporting frequency. The threshold of the itemized VAT was reduced in 2015 to help detect risky invoicing networks. This reduction became possible thanks to enhanced capacity to handle an increased amount of data by the tax administration. The reporting frequency in the VAT returns was increased for newly established taxpayers without a predecessor for the first two years of their business activity recently. At the same time, taxpayers became required to report their VAT declaration on a quarterly basis if sales exceed a certain amount in the second year preceding the tax year (NTCA, 2017).

18. New measures are being introduced in 2017 to further improve tax compliance. Online cash registers are being extended to the services sectors. These sectors include taxi services, foreign exchange bureaus, repair and maintenance of vehicles and activities related to spare parts sale, laundry services, and various services improving physical well-being. The authorities are about to introduce a system of online invoicing that aims at reducing fraud through making the data reporting on invoices a real-time process and enhancing the collection of overdue tax liabilities.

19. These reforms have led to an improved VAT tax compliance and revenue. VAT collection increased from 8.9 percent of GDP in 2013 to 9.7 percent of GDP in 2015.8 Given no significant changes in policy in terms of rate, the factors that could help explain the improvement are the tax base and compliance. The increase in tax collection was higher than the estimated increase of the tax base. This suggests that improved compliance related to tax administration reforms was the main factor behind the increase in revenue (MNB, 2015). Indeed, improvements in VAT performance coincided with the implementation of online cash registers in 2014 and its expansion in 2015 as well as with the implementation of the EKAER monitoring system in 2015 (MfNE, 2016).


Estimated VAT and purchased consumption of households

Citation: IMF Staff Country Reports 2017, 124; 10.5089/9781484300473.002.A002


20. The estimated VAT compliance gap has, therefore, decreased markedly since 2013, but remains at elevated levels. Based on the European Commission (2016), it is assessed that the VAT gap (defined as a difference between the theoretical tax liability and actual VAT revenue) was stable at around 22 percent of the theoretical liability between 2010 and 2013. It then shrank by 4 percentage points in 2014, and has most likely shrunk further in 2015 (MfNE, 2016). While being reduced, the level of the gap is still significant compared to other EU countries. Estimated at above 15 percent, it is markedly higher than the 10 percent EU average. This level is, however, lower than many of Hungary’s regional peers.

21. Policy simulations point to a high dividend from further reducing the VAT compliance gap. Higher VAT revenue would lead to lower deficits, and thus lower debt stock and cost of financing. Consequently, an increase in VAT revenue would reduce the stock of debt more than proportionally in the steady state. Under the assumption of gradual elimination of the gap over next five years, the primary balance would strengthen from around 0 percent to around 2 percent of GDP, the overall balance would improve from around -2.5 percent to almost a balanced budget, and public debt would decline to around 62 percent of GDP.

D. Conclusions

22. Improving tax compliance can be key in shifting segments of the grey economy into the formal sector. Although the grey economy in Hungary has been shrinking and is at par with peers, it remains sizeable. Tax noncompliance and undeclared work are one of the main drivers of the grey economy in Hungary. The authorities have embarked on a comprehensive strategy to improve tax compliance following the global financial crisis. This strategy has already yielded sizeable gains and VAT collection has improved in recent years. Consistently with this, the VAT gap estimates point to the reduction in the gap, coinciding particularly with the implementation of the online cash registers and the electronic system monitoring the road transport of goods movement.

23. Mobilizing additional VAT collection would help lower the fiscal deficits, which would translate into lower debt and financing cost. Simulations suggest that eliminating the VAT gap would reduce the overall deficit by around 2 percentage points and public debt by around 8 percentage points, reducing the exposure to shocks and creating fiscal space for other initiatives.

24. Efforts to shift more of the grey economy to the formal sector should be multi-faceted. In addition to strengthening tax administration, it is also important to streamline regulations and improve the business environment in general in order to support the effort to increase tax compliance as well as to facilitate productivity gains and boost growth and job creation.


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Prepared by Mariusz Jarmuzek and Borislava Mircheva.


Schneider and Buehn (2016).


Kreko and Kiss (2008) estimate that tax evasion resulted in a transfer of almost 8 percent of GDP from taxpayers to tax evaders in Hungary between 2005 and 2006.


The items subject to reduced rates were increased in 2016 and 2017.


For selected country experiences, please see IMF (2016). For example, the Estonian Tax and Customs Board has developed into a full service-oriented revenue body that (i) allows maximum simplification in the fulfillment of tax liabilities, through extended use of technology; (ii) conducts upgraded risk analysis through new methods for data analysis; and (iii) has developed capacity to administer tax arrears very effectively through improved information systems.


VAT is estimated to have slightly reversed to around 9.5 percent in 2016, which can be attributed to lower absorption of the EU funds and the introduction of reduced rates on selected items.

Hungary: Selected Issues
Author: International Monetary Fund. European Dept.