Published: October 01, 2011
Hungary was a frontrunner in the transition process as the country was among the first to open up for foreign investments and new technologies. Per capita foreign direct investment is high, and foreign companies flooded the country in the 1990s to benefit from a rapidly improving infrastructure and highly-skilled labour at a relatively low cost. Export and investments were the primary drivers of growth and manufacturing; manufacture of car parts and electronic devices became the key drivers of the economy. Exports now account for almost three-quarters of the national income and most of these goods are sold in the EU countries with Germany playing the leading role among export destinations.
The privatisation process started immediately after the fall of the Communist regime in 1989 and most of the financial, energy and telecoms sectors are now owned by foreign companies. Hungary plays a key role in transportation due to its location at the centre of Central and Eastern Europe. The largest companies are often subsidiaries of large Western European manufacturers and recently Daimler, Audi and GM’s Opel announced expansion of production.
Early privatisation and openness to foreign capital allowed for convergence from the start, but this catch-up process was not without problems. Repeated fiscal overspending at election times, low levels of employment and high inflation remained a challenge. Excessive loosening of the budget policy took place basically around all elections in the last 20 years. This first became clear in 1995, when the Socialist government had to carry out a large-scale austerity programme, the so-called Bokros package, which was one of the deepest fiscal consolidation programmes ever in emerging markets. Despite this, the budget deficit rose again to unsustainable levels in the 1998 election and similarly every four years.
The export and investment driven growth was replaced by domestic demand, followed by deteriorating external balance.
The 2002 election was especially problematic as spending occurred not just before, but also after the elections. For example, there was the introduction of a heavily subsidised mortgage loan system, an extra one-month pension and an unprecedented 50% pay rise in the public sector. These measures did not just put the economy on an unsustainable fiscal footing, but also undermined competitiveness. The export and investment driven growth was replaced by domestic demand, followed by a deteriorating external balance. Although the growth rate remained relatively high at around 4%, the economy adopted a growth model that relied more on consumption and less on export, so external imbalances quickly emerged. This fiscal challenge proved to be more difficult than before because the government was not able to use inflation to generate revenues. After a decade of moderate inflation levels between 10% and 35%, the central bank adopted an inflation targeting regime in 2001 and disinflation targets were set. This meant that the disinflation process took place at the time of fiscal loosening.
Financial markets reacted erratically to the situation and there were several periods of market turbulence in 2003. The central bank tried to stabilise markets with sharply higher rates as it was trying to lower inflation to the targeted levels. Although a double-digit base rate level helped to pre-empt attacks against the currency, it also had adverse consequences. Foreign currency based loans became popular among households and the country’s external indebtedness started to grow. Unfortunately, most of these loans were denominated in Swiss francs because of the wide interest rate differential. [[[PAGE]]]
After the 2006 elections, the re-elected Socialist government announced a severe fiscal consolidation package. The ballooning budget deficit would have exceeded 10% of GDP in that year if austerity measures had not been undertaken. The government wanted to lower this to below 3% of GDP by 2008 by slashing expenditures and raising taxes. Tax increases, however, slowed down the economy to almost zero, while households were borrowing more and more to smooth out their consumption. This household borrowing was so strong that despite a lower budget deficit of 4% of GDP, the country’s external financing situation did not improve and it continued down the path to growing indebtedness. Eventually the country became highly vulnerable to external financing just before the financial crisis hit markets.
With a gross external debt level at 140% of GDP - almost half was net debt - it was no surprise that Hungary was the first country that needed help from the IMF in the crisis. The programme set aside €20bn or 20% of GDP for government financing at the cost of a painful spending reduction plan. The government did not want to carry this out and a minority government took over, deciding to cancel the extra one-month pension, freeze wages in the public sector and cut back on social spending. The sharp fall in consumption turned the external balance into a surplus and the country’s indebtedness started to improve, albeit from a very high level. The government debt was stabilised at 80% of the national income.
After the Parliamentary elections in 2010, the centre-right government introduced several new measures. The new government wanted to improve competitiveness via tax cuts and lower the public debt level at the same time. Some of the measures were different from textbook recommendations and were called ‘unorthodox’. For example, there was a special tax introduced on some sectors of the economy: banks, insurance, telecoms, retail and energy companies. These taxes were originally planned for a three-year period, but later the government decided to keep the tax on the financial sector permanently at half the rate. The government wanted to increase revenues, but it also wanted to attract manufacturing investments into the country. It also decided to scrap the mandatory private pension fund system and nationalise most of its asset to lower the public debt level.
Secondly, a large scale tax reduction programme was announced. The corporate income tax rate was lowered to 10% up to Ft500m annual revenues. A flat personal income tax system was introduced with a 16% rate - in 2012 and 2013 the tax base will incorporate the social contribution paid by the employer, resulting in an effective personal income tax rate of 20.4%. This super-gross tax calculation will be phased out gradually and the government aims to have one of the lowest personal income tax rates in the EU. A family tax allowance was also introduced depending on the number of children, in order to improve the low birth rate.
Lower personal income tax is expected to improve the employment situation. At 55%, Hungary has the second lowest employment rate after Malta in the EU bloc. This creates a very difficult situation for the government budget. Taxes are paid by a minority of the workforce and they carry a very high tax burden, which encourages workers to minimise their tax payments and to become inactive through early retirements and social benefits. More unproductive people means that the tax burden is shared by fewer workers, encouraging them still further to avoid taxes,
Thirdly, in order to cover the revenue fallout from lower taxes a wide-ranging spending reduction programme was announced. This included lower administration costs, cutting back spending on social benefits – for example, cutting unemployment benefit from nine months to three and decreasing subsidies on public transport. Shrinking social benefits will further enhance the labour supply and the government will use some of these funds to organise public work for the unemployed. Here the goal is to have a step-by-step increase in the income achievable from social benefits to public work with the minimum wage being above these levels. This is expected to generate higher employment, which will ease the burden on the budget through both higher tax revenues and lower social spending.
The government also set ambitious fiscal targets, like the 2012 budget deficit target of 2.5% of GDP. The budget deficit is planned to decrease further to 2% of GDP in the following years and Parliament incorporated into the new constitution a debt rule that sets a long-term target of below half of the national income. This would all guarantee Hungary’s debt level to fall gradually from last year’s 80% of GDP level.
The economy has been slowly emerging from the deep recession after the global financial crisis, but the relatively large exposure in Swiss francs has been weighing on domestic demand. Employment has also been growing in the private sector, while overall employment growth is expected to improve only slowly as there are layoffs in the public sector. Overall, if fiscal consolidation goes ahead with tax reductions, the economy may slowly move away from the danger zone and should establish a more stable convergence path.
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