This is why the Hungarian budget is permanently imbalanced

Every year, the European Commission publishes a report assessing economic developments in Hungary from the point of view of macroeconomic vulnerabilities to help prevent and correct macroeconomic imbalances. One of the special topics of the 2024 in-depth review (IDR) is the change in the Hungarian tax burden and its causes.

The topic is particularly interesting given that there have been problems with the budget balance for years. In these circumstances, a reduction in the tax burden is not really good news either, since if it leads to a deficit, the state will become indebted, and the rising interest expenditure will increase the revenue needs of the budget in the longer term.

Declining tax-to-GDP ratio

Hungary’s tax-to-GDP ratio has been declining in recent years, falling from 39.1% of GDP in 2017 to 35.1% in 2022. (Total income centralisation is much higher, at around 42-43%, since the state does not only collect money in the form of taxes, but the paper focuses specifically on the tax burden.) 

This box lays out the drivers of this process by decomposing changes in the tax-to-GDP ratio since 2009 into:

1. a discretionary component that captures the impact of changes in the implicit tax rates of consumption and labour taxes, and
2. other revenue windfalls/shortfalls due to changes in the GDP composition

On the basis of these factors, the most characteristic trends in recent Hungarian tax history can be identified.

The tax cuts implemented since 2017 have offset the revenue-increasing impact of earlier consumption tax hikes.

The most spectacular (and better known) are the steps in the first group:

• In the early 2010s, to support fiscal consolidation and enable the labour tax burden to be lowered, Hungary increased the role of consumption taxes in the tax mix, most notably by increasing the VAT rate to 27% in 2012, improving VAT collection, and introducing certain sector-specific taxes (e.g., on financial transactions and telecommunication services). These measures increased the implicit tax rate on consumption by 4 pps between 2011 and 2022 and boosted tax revenue by some 2.2% of GDP.
• Since 2017, Hungary implemented further labour tax cuts to stimulate employment growth. Employers' social contributions were gradually lowered from 27% of gross wages in 2016 to 13% in 2022. This decreased the implicit tax rate on labour by some 5 pps, and reduced tax revenue by 1.6 pps of GDP by 2022.
• In addition, the reduction of the corporate tax rate to 9% in 2017 lowered the tax-to-GDP ratio by a further 2.2 pps, by 2021, before increasing again in 2022 due to the introduction of the temporary windfall profit and sectoral taxes, levied on companies in the energy, financial and retail sectors.

On top of the above factors, changes in the composition of GDP exacerbated the decline in the tax-to-GDP ratio, decreasing it by 3.2 pps between 2009 and 2022. Between 2012 and 2023, the share of the consumption tax base in GDP dropped by 4.0 pps, while the share of the labour tax base in GDP fell by 5.3 pps (Graph 2.5). These trends can be explained by structural changes in Hungary’s economy:

• Investment and export-led economic growth decreased the weight of consumption in GDP. The GDP share of ‘tax-poor’ expenditure-side components of GDP, such as corporate investments and exports, which are not in principle liable to VAT, has increased strongly since 2009. This increase has also been supported by policies promoting high investment levels, with a particular focus on export-oriented foreign direct investments.
• The falling wage share in the Hungarian economy has hampered growth of labour tax revenue. Between 2009 and 2021, growth in wages has remained below the growth in profits, therefore the profit share increased by some 4 pps of GDP. This process was driven partly by capital accumulation, and to some extent by the cuts to social contribution rates implemented since 2017, which were not fully passed on to workers in the form of higher salaries and employment. More recently, the profit share rose further in the context of commodity price and inflation shocks.

The invisible impact

Overall, therefore, the reduction in the tax-to-GDP ratio in the economy as a whole in recent years can be broken down as follows.

Increases in taxes on consumption have increased the tax burden, while increases in taxes on labour and capital have reduced it. The balance of these three direct effects is only slightly negative, but the 'invisible' tax-reducing effect of structural changes in GDP is significant.

Put simply, the weight of heavily taxed consumption has diminished (compare this with Hungary's fall in the EU's per capita consumption ranking), which has in fact overcompensated for the direct impact of the rise in consumption taxes.

The permanent erosion of tax revenue is constraining fiscal policy,

the EC said.

"The tax cuts enacted since 2017 have partly reversed the fiscal consolidation efforts of the early 2010s and, together with the structurally-driven tax revenue shortfalls, have permanently decreased the tax-to-GDP ratio. Without a commensurate adjustment of expenditure, these policies resulted in elevated headline deficits and an expansionary fiscal stance.

"The temporary introduction of the windfall profit and sectoral taxes in recent years has only momentarily addressed this challenge, and risks leading to market distortions.

Unless Hungary shores up tax revenue in a sustainable way, the needed fiscal adjustment is likely to disproportionately affect the expenditure side of the budget,

the EC concluded.

Cover photo: Getty Images