Tax Tinkering Won’t Fix Hungary’s Growth Problem

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Tax Tinkering Won’t Fix Hungary’s Growth Problem

The country, which was the darling of foreign investors in the early 1990s after communism ended, has seen confidence ebb as a result of its confusing and costly tax regime, Reuters reports. While neighboring Slovakia, once far behind Hungary, has boomed with billions of dollars of investments, growth here slumped to less than one percent in the Q3 of 2007 from the impact of higher taxes to slash the budget deficit. Slovakia, by contrast, introduced a flat tax of 19%, which stimulated the economy, increased tax revenues and cut the budget deficit. But serious tax reform is unlikely in Hungary as the Socialists, the main government party, are running scared as polls show their support at under 20% ahead of elections in 2010. The Socialists say the budget allows tax cuts of Ft 100 billion ($573.3 million) from 2009 to stimulate business. The smaller coalition party, the Alliance of Free Democrats (SzDSz) says up to Ft 600 billion could be found with budget savings.

Economists say neither plan is a lasting solution and timidity in cutting state spending is the reason why. Even with its new-found budget austerity, Hungary’s government is still planning to spend more in 2008 than it did last year, at Ft 13,802 billion ($79.12 billion) against Ft 13,180 billion, excluding spending by local governments. “Hungary should be brave in its tax changes and should have a clear concept,” said Zoltán Török, economic analyst at Raiffeisen, an investment bank. “But as long as budget spending is not reduced significantly it is difficult to transform the tax system in a brave manner.”

Taxes groving
Moves to fix Hungary’s huge budget deficit have been largely successful and the government expects it to drop to 4% of GDP this year from 9.2% of GDP in 2006, by far the highest in the EU. That has put the country back on the path to euro zone entry and provided some shelter from the global credit crisis. But it has been achieved mostly on the back of higher taxes - among them a four percent “solidarity tax” for high rate personal tax payers and for businesses at a time when other countries in eastern Europe have slashed taxes.

Even before the tax rises introduced in 2006, Hungary had the third highest tax take on single workers in the OECD. At around 51%, only Belgium and Germany had a higher tax take on a single taxpayer earning the average wage. While there have been efforts to whiten the huge grey economy, which has boomed since the end of communism and now accounts for 17-18% of GDP, according to the government, it still pays to try and escape the tax net. Hungary has one of the lowest employment and activity ratios in the European Union, while illegal employment is widespread. Experts say the tax base needs to be broadened, allowances scrapped and corporate taxation made more transparent. One way to combat tax evasion would be to trim high marginal tax rates, said Péter Oszkó, chairman and CEO of Deloitte, a large auditing firm, in Hungary. “The biggest problem is that a narrow layer (of the population) has an irrationally high tax burden,” he said.

Complication
Frequent tax changes have led to complaints from investors like carmaker Audi AG and by French drugmaker Servier, which said last month it might not have picked Hungary for new operations had it not already been here. The OECD says Hungary should cut its high social security contributions, mainly those paid by employers, who pay over 30% on top of taxes and contributions paid by employees. But if contributions are cut lost revenue will have to be replaced either from a property tax, which would be politically unpopular, or by raising the top 20% Value Added Tax rate, which would be inflationary. Eszter Gargyán, an economist at investment bank Citigroup, argues that rather than simply measuring the tax take, a predictable system is key. “Cutting social contributions (by companies) in it self is not enough, the main thing is that (investors) should have trust in the tax system, that it is stable," Gargyán said. If the Socialist-led coalition loses power in 2010 it will be the right-of-centre Fidesz, which will likely win. It has traditionally favored tax breaks for housing and families, as well as for small businesses.

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