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Country Study, Hungary


Country Study, Hungary
      Dmitri Maslitchenko dmitri@mailroom.com

Introduction to Hungary’s political history
      Hungary has had a long and volatile history of political and economic
change.  Hungary as a organized society dates back  before 1000 AD and has
been ruled by different monarchies and foreign regimes every since.  This
brief introduction  will outline Hungary’s political and economic history
starting with Hungary’s “Post-1945 World War II era”.
      During WWII Hungary fell under German control until the end of the
war.  After Germany’s defeat in WWII,  a commission was established among
allied forces (American, Soviet, and British) in which had ultimate
sovereignty over the country.  However, since the leader of the commission
was a member of Stalin’s inner circle, the Soviets exercised absolute
control.(Wash. Post., 1)     The Government that was provisionally
instituted in Hungary after WWII was shortly dissolved and  the Hungarian
Communist Party replaced them in the 1945 elections.
      The (HCP)Socialist government had instituted radical land ownership
reforms and had made many utilities, banks and heavy industries state ran.
Then in 1949 at the beginning of the Post-Cold war era the Soviet’s  gained
control of Hungary and in 1949 Hungary adopted a Soviet-style constitution
and formed the Hungarian People’s Republic.  Hungary’s economic state up
until the mid 1950’s was a  economy similar to that of a Soviet modeled
Centrally Planned Economy.  However, the economy in the mid 1950’s had
begun a rapid deterioration which led to more political reforms for
Hungary.(Wash. Post, 2)
      In the mid 1950’s Hungary  attempted to withdraw from the Soviet
sponsored Warsaw Pact and announced their neutrality and sought backing
from the UN.  However, the United Nations failed to respond, as they were
preoccupied in other areas of the world. As a result of lack of UN support,
Soviet troops invaded Hungary and regained control, during the invasion
many Hungarians fled to other countries.  This new Soviet culture in
Hungary had a more liberal culture and economic path as did the Soviet
regimes of the past.  This Soviet government had become relatively
complacent for the next two decades until about the early 1980’s.
Start of Transition
      By the 1980’s Hungary’s government had some lasting economic reforms
and was responding to political pressure to encourage more trade with the
west.   This new plan to trade more with the west for economic stimuli led
to huge foreign debt as a result of unprofitable industries.  These new
economic troubles as well as Hungary’s strong nationalism to control their
own destiny were Hungary’s first steps to a Western style democracy.  By
the late 1980’s radicals with the party as well as intellectuals were
calling for change.  In 1988 civic activism had accelerated to an all time
high and a Reform Socialist leader, Imre Pozsgay was elected.  Along with a
new leader, Hungary also adopted a, “democracy package”, which included:
trade union pluralism, freedom of association, freedom of press,  freedom
of assembly, a new electoral law, and radical revisions to their
constitution.(Wash. Post,4)
Hungary’s steps to a market economy
      In the following year the Hungarian parliament adopted legislation
providing for multiparty elections and direct presidential elections.
Hungary now had a new vision of government, the government now was to focus
on human and civil rights, and to ensure the separation of powers among the
executive, legislative and judicial branches.
      One major step for Hungary in asserting its move to a market economy
was to restructure its national security.  In doing this Hungary reduced
it’s defense expenditure by 17% and reduced its armed forces by 30% between
1989 and 1992, thus dissolving their membership in the Warsaw Pact .
Currently Hungary is trying to develop Western-style defense force to join
NATO.(Wash. Post, 5)
Current Political Structure
      The current political conditions in Hungary are a system of many
checks and balances.  The Prime Minister whom is elected selects the
ministers in the cabinet.  Each of the cabinet members presides before four
parliamentary committees in open hearings.  The legislative body in Hungary
is a unicameral house and is the highest authority in the state.
Current Political State
      The Hungarian Socialist Party was re-elected in1994 in a multiparty
election after receiving 54% of the popular votes.  Although the (HSP) had
taken back control of the government in the 1994 elections, the party has
announced its intentions to: “continue economic reform, privatization and
to preserve political rights.”(Wash. Post, 6)
Economic Structure in Hungary
      Hungary’s history of economic vitality has predominately been
agriculture.  In 1950 , over 50% of Hungary’s work force worked on the
land.  Hungary’s percentage of workforce working on the land in 1993  was
7%.    Hungary’s agricultural decline is directly tied to lack of
investment in the 1970’s and the 1980’s.  Hungary’s decline is also a
product of  large amounts of foreign debt that were accumulated in the
1970’s and 1980’s.(6)  The net foreign debt in 1972 was about 1
billion(U.S. dollars) and in 1993 Hungary’s net foreign debt was 15
billion(U.S. dollars).  Although Hungary has the highest per-capita debt in
central Europe their repayment record is stellar.(Wash. Post,7)  One of the
major functions to Hungary’s success to transition is their role in revenue
policy.
Hungarian Tax Reform

Hungary's movement from a centrally planed economy to a market economy has
lead to massive tax reforms in the former soviet satellite country.  These
taxes basically fall into three major categories: Value Added Tax, Personal
Income Tax, and Corporate Income Tax.  In this section of the paper I will
first examine the attributes and disadvantages of the separate categories
of the taxes and compare them to the former means of revenue collection.
Next, I will demonstrate the success (or as the case may be, failure) of
such taxes.  Finally,  I will write about what effects Hungary has
experienced due to the tremendous changes in the tax system.
Value Added Tax
On January 1, 1988 Hungary introduced a Value Added Tax (VAT) as part of a
ovement from a socialist centralized country to on with a market economy
(Newbery 1).  This tax is similar to the tax currently operating in the
European Union member states.  This tax is interesting because it is an
inclusive tax.  That is a tax in which the base is included in the invoiced
amount of the good or service.  In other words the tax is passed down to
the end customer and in turn the seller is reimbursed the amount of taxes
paid on that particular good or service.

The concept of a Value Added Tax (VAT) was something that was entirely
different to managers that were used to output based goals (in the old
system) as opposed to budgets and cost minimization as practiced by their
western counterparts.  The Value Added Tax (VAT) has become a vehicle to
flush out businesses that are experiencing market failure that demonstrate
no reasonable need to continue to operate (there are obvious exceptions to
this such as utilities, etc....).  It also cut down on over production of
certain goods.

The Value Added Tax (VAT) is also a way that a country such as Hungary can
use to encourage (or as the case may be discourage) certain types of
businesses in their country.  According to Deloitte & Touche the standard
rate for the Value Added Tax (VAT) is currently 25%.  However,  many
products and services such as basic food products, medical instruments, and
utilities are charged 12% .  In addition,  various supplies qualify for
complete exemption such as education,  cultural services, sport events,
health services, and services contributing to scientific research and
development (D&T 8).
Personal Income Tax
Along with the Value Added Tax (VAT) the Personal Income Tax (PIT) was also
introduced to Hungary in 1988.  The Hungarian Personal Income Tax (PIT) is
a progressive tax with a universal additional tax for investment.  The tax
is based on individual earnings from all forms of work, though interest
income is not taxed if certain conditions are meet (D&TII, 1).    As shown
in figure 1.1 the progressive tax rates on income earned at work range from
0-44%.

fig. 1.1

|Personal Income Tax Rates        |                                 |
|                                 |                                 |
|Level of Taxable Income HUF      |Rate Applicable to Level (%)     |
|Up to 110,000                    |---                              |
|100,001 - 150,000                |20                               |
|150,001 - 220,000                |25                               |
|220,001 - 380,000                |35                               |
|380,001 - 550,000                |40                               |
|Over 550,000                     |44                               |

Source 1996 Deloitte & Touche LLP

The Hungarian Personal Income Tax (PIT) has several interesting features.
The first feature that is unique is that all Hungarians  are taxed
separately.  In other words, unlike the American Tax system where a family
can jointly file the Hungarians prefer (for ideological reasons) to file
individually.  However, this system is not with out it's flaws.  The
problem that tax administers run into is when one spouse stays at home to
look after the children.  The reason for this difficulty is the one wage
earner is subject to heavier taxation than two wage earners making the same
total.  Tax administrators however are reluctant to change the current
system because of the administrative simplicity.

A second feature of the Hungarian Personal Income Tax (PIT) that draws
attention to itself is the fact that any income earned through deposits and
securities are tax free if the interest rates are lower than that of the
National Bank of Hungary.  According to D&T the National Bank of Hungary's
interest rate in January was 25%.  This means that all bank deposits that
pay lower than 25% are tax free.  However, If an individual were to make
28% on investment he/she would be subject to a 20% tax on the additional 3%
(as shown in figure 1.2).

fig. 1.2
                        Initial Investment
100,000 HUF
                        Interest Paid on Investment
                in Bank X  (28%)                       128,000 HUF
                        Interest Paid on Investment
                National Bank (25%)                 125,000 HUF
                        Taxable Interest Income                     3,000
HUF
                        Taxes Due
  600 HUF

This aspect of this tax allows for fair treatment to those who would
otherwise lose their money putting it in accounts that could not stay up
with the tremendous inflation that several countries in eastern Europe face
due to their recent transition to a market economy (Newbery, 6).

As was true with the Value Added Taxes (VAT) the Personal Income Tax (PIT)
also has exemptions.  The following is a list of examples of items exempt
from tax (Okno 2).
Social Security allowances
Gains of up to HUF 100,000 from the non commercial sale of moveable
                                    property
Retirement gifts of up to HUF 10,000
Compensation of defined working clothes

In addition as of January 1995 tax credits against taxes owed were offered
in several areas such as social security contributions by the employee, for
individuals making under 500,000 HUF, for installments on loans for
dwellings, charitable contributions, and for special savings accounts.
Corporate Income Tax
The corporate tax is levied on all businesses, no matter how large or
small, the same way.  As of January of 1995 the corporate income tax has
been reduced from 36% to 18% on undistributed profits before tax.  this is
called either the additional tax or the calculated tax.  After this tax has
been levied the profits are then distributed among the shareholders and an
additional 23% is taxed to the shareholders.  To illustrate this tax figure
1.3 demonstrates how the tax is calculated.
fig 1.3
Calculation of Additional Tax
|                                 |HUF                              |
|Income before tax                |100.00                           |
|Calculated at 18%                |(18.00)                          |
|Income after tax to be           |82.00                            |
|distributed                      |                                 |
|Amount available for distribution|66.67                            |
|after payment of additional tax  |                                 |
|(82/1.23)                        |                                 |
|Total Tax Paid                   |33.33                            |
|Effective Rate of the additional |15.33%                           |
|tax (% of income before tax      |                                 |

Source Deloitte & Touche LLP

In addition to the corporate tax employers must also make Social Security
contributions.  Typically, employers must make a contribution at a rate of
44% of their gross salary.  Employees are required to make a 10%
contribution, however, it not unlikely to see individuals putting more than
10% away of retirement.

Another tax that employers are subject to is the Unemployment Fund
Contribution.  This is to continue to support the unemployed between work.
Employers must pay 4.2% of their employees gross salary and wages to the
Unemployment Fund.  Employees are required to pay 1.5% of their salary.
However, employees'  contribution is tax deductible.

Training Fund Contributions is yet another tax that corporations are
subject to.  This tax is to provide for the cost of training employees.
This contribution is currently paid by the employer at 1.5% of the total
payroll.  This tax is for corporate income tax purposes.

As with other Hungarian taxes exemptions are offered to certain kinds of
business.  Hungary grants exemptions on a case by case basis and either
dose not grant an exemption or grants a 100%, or 60% exemption.  The figure
below shows how  companies are allowed to use their exemptions.

fig. 1.4
Percentage of Taxes due under specific exemption
|                      |18% subject to        |23% subject to        |
|                      |Corporations          |Shareholders          |
|100% Exemption        |100% reduction        |No Reduction          |
|60% Exemption         |20% reduction         |No Reduction          |

Businesses view this set of taxes as equitable and do not squabble over the
fairness of the taxes.  They seem to be more interested in how to receive
tax exemptions and want reform in the exemption granting side of the tax
system (Newbery, 8).  This is good because of the infectious shadow economy
in other former soviet countries.  This means that businesses will be more
willing to pay taxes that are due to the government.
So What Does this mean for Hungary?
Newbery argues that the Hungarian tax system is at least as  egalitarian as
any where else in the world as far as an equal distribution of taxes.
Especially since the method of redistribution is so good at keeping poverty
remarkably low.  While the transition still will put a gap between the
“haves and the have nots”, the government needs to keep its eye out for the
most vulnerable such as the old and unskilled.  Many argue that because of
the rough transition people may become disillusioned with a market economy
and never realize the gains that the countries leaders have fought so hard
for.  However with vigilance and a little bit of patience Hungary will
reach its goal.
Privatization
In addition to using tax collection as a source of raising revenue, Hungary
has turned to privatization to offset Hungary’s 31 billion USD national
debt (Galai, 1).  The sale of government controlled industries such as
natural gas, oil, and electric powered utilities has earned the government
over 1.4 billion USD in the past year.

Recently the Hungarian Government decided to sale shares in eight of the
fourteen nationally owned electrical power and distribution companies.  A
German consortium agreed to pay 180 billion HUF for the shares and
controlling interest in the former government controlled utilities.

In addition to the sale of the utilities Hungary has had discussions about
selling the National Bank of Budapest to investors.  However analyst point
out the bank will have to spend the next year fixing up the bank before
they can think about selling it.  Government officials would expect a heavy
return if the bank were to be sold.

While some analyst applaud the actions the government has taken others
wonder who is really in control in Hungary.  Is the government still
calling the shots or is it the foreign investor with the most money
invested in a majority of Hungary's' industry.  Another key step to
Hungary’s transition to a market style economy is expenditure policy.
Expenditure Policy
Along with changing revenue policy expenditure policy is a crucial role of
any government and especially important policy questions for governments in
transition.  Hungary’s main policy stance on expenditures is to try to
match in-kind efforts and expenditure policy to specifically earmarked
funds.
Defense spending
As mentioned in the introduction when Hungary decided to withdraw their
membership with the Warsaw Pact they decided to drastically reduce their
military expenditure.  Hungary’s reduction in defense spending was a key
decrease in fiscal consolidation to help decrease their ever rising budget
defict.  The graph in Fig. 1.5 represents Hungary’s decrease in defense
spending over the last ten years.

Fig. 1.5
[pic]Source:  SIPRI Military Expenditure Database

Social Welfare Reform
Reforms to Hungary’s Social Welfare systems have been plentiful.  Decreases
in Welfare systems have mainly been reallocation of subsides on a stricter
criteria basis.  Hungary has made constant efforts to restructure social
programs in which have proven to be ineffective.  One example is the reform
of the “Family Allowance System.”  After a evaluation of the old program it
was proven to be cost ineffective and replaced by a new “Family Support
System”.   This new “Family Support System” target families in need based
more on income criteria and targeted people in the greatest need.  Another
key social expenditure reform was that of pension and health
programs.(CCET, 2)
Pension and Health Programs
Hungary experience great abuse in the areas of health and pension programs,
but have taken steps in the right direction to help correct the situation.
One such of these decisions was that of increasing the number of days
employers are liable for sick pay.  This reform travels in the right
direction because the policy had reduced the Social Insurance Fund and also
created minimum incentives for abuse of the system.  Much more needs to be
done  in the way of pension and health reform however this policy shows a
step in the right direction..(CCET,2)
Expenditure Summary
The underlying tone of Hungary’s expenditure policy is that of reducing the
budget deficit without creating economic turbulence.  Hungary faces many
obstacles in trying to reduce their budget deficit. Such obstacles are
rising inflation and high rates of unemployment  these problems lead to
substantial social problems.  Regardless, Hungary is still looking the
right “social safety net”  but not at the expense of its economic viability
and without effecting production and output ion a negative way.
Conclusion
Hungary has come a long way since the initial transition from a centrally
planed economy to a  market economy in 1988.  However, Hungary continues to
strive to overcome the obstacles described in this paper.  The transition
has been difficult for the people of Hungary.  People accustom to a
centrally planned economy are not typically faced with subjects such as
unemployment or cost budgeting.  Therefore, many Hungarians have become
disillusioned with the new market economy.  However, most (including
socialist) have insisted that economic progress continue.  In order for
Hungary’s economy to continue its success it must remain to be egalitarian
in both the way it collects cash through taxes and the way it redistributes
resources to the people of Hungary.  Hungary must be sensitive to the
vulnerable such as the unemployed and the unskilled, during the sometimes
unforgiving transition to a market economy.

                                Bibliography

           1. CCET. “The Center For Co-Operation With The Economies in
              Transition.” OECD-OCDE.
              Http://www.oecd.org/sge/ccet/hun_fisc.htm.

           2. Sipri.  “Military Expenditure Database”.
           2. Washington Post. “ Hungary: State Department Notes”
              Washington Post.Com.  http://www.washingtonpost.com/wp-
              s…term/worldref/statedep/hungary.htm
           3. Deioitte and Touche LLp, “Taxation in Eastern Europe”.
              Webmaster@dtomlinr.com.1996.
           4. Galai, Andra’s.  “Sale of Eight Electric Co.’s Jolts
              Privitization Back to Life.”
              Http://www.iqsoft.hu/economy/page95_4/privat.html. 10/17/96.
           5. Galai, Andra’s.  “Gathering momentum.”
              Http://www.iqsoft.hu/economy/page95_4/csaba.html. 10/17/96
           6. Langyel, Laszlo.  “Towards a new model.”
              Http://www.iqsoft.hu/economy/page95_4/langyel.html. 10/17/96.
           7. Newbery, David.  “An Analysis of the Hungarian tax Reform.”
              Center for Economic policy Research. #558 May,1991.


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