The Hungarian tax system is in big trouble, Brussels sounds the alarm

Hungary’s tax-to-GDP ratio has been declining in recent years, falling from 39.0% of GDP in 2016 to 35.1% in 2023.

This decline is largely due to labour tax cuts and a reduction in the corporate tax rate, which were implemented since 2017 to stimulate employment growth and investments, the Commission said in its latest in-depth review.

Changes in the composition of GDP have exacerbated the decline, as the share of the consumption tax base and the labour tax base in GDP decreased significantly,

the EC said (see 2024 In-depth review for Hungary).

They refer to the fact that since 2022, the two of the most important factors for VAT revenue - investment and consumption - have not helped Hungarian growth. Although consumption is showing signs of recovery, the Hungarian Central Statistical Office reported a 13.8% decline in investment in 2024, the sharpest fall since the change of regime.

The problem, as the analysis points out, is that Hungary’s tax system is characterised by the strong reliance on consumption taxes (13.5% of GDP in 2023, in comparison to EU average of 10.5%), as a result of the increase of the VAT rate to 27% in 2012 and introduction of a series of sectoral consumption-related taxes.

Labour taxes account for a relatively low share of GDP in comparison to the EU average (14.8% in 2023, as compared to 20.0%) and their share decreased over time due to multiannual cuts in social contributions enacted since 2017. Revenue from capital taxation, at 6.8% in 2023, remains below the EU average of 8.5% of GDP, largely as a result of low CIT rate.

Revenue from environmental taxation is close to the EU aggregate (2.2% of GDP in 2023 as compared with 2% in the EU). The property taxes, in particular recurrent property taxes, remain relatively low compared with the EU aggregate, at 0.8%.

The European Commission says that partly as a consequence of these, the Hungarian tax system suffers from a number of specific weaknesses, which further limit the government's room for manoeuvre and add to the economic challenges.

The EC notes that revenue from the corporate income tax (CIT) remains low. The CIT rate, at 9%, is the lowest in the EU (EU average is at around 21%). The forward-looking average effective tax rate (ETR) was 11.1% in 2022 (third lowest among EU member states; EU average around 19%).

The EC pointed out that the low statutory tax rates, combined with a limited tax base due to various tax incentives and exemptions reduces the tax revenue generated from CIT. Additionally, the low statutory rates and the lack of withholding tax on dividends, interest, and royalties increases the risk of aggressive tax planning

Tax expenditures are estimated at some 2.1% of GDP in 2022.

The Hungarian tax system is characterised by numerous tax deductions and exemptions that bring limited economic and social benefits relative to their budgetary cost,

the EC said.

These include among others:

• the personal income tax exemptions for workers under age 25 (0.2% of GDP),
• the deductibility of donations to sport clubs from corporate tax obligations, up to 80% of the total tax obligation (amounting to 0.2% of GDP in 2022),
• the exemption of employed pensioners from social contributions (0.36% of GDP in 2022), and
• the personal income tax exemptions for women with at least 4 children (0.05% of GDP in 2022) and mothers under age 30.

Subsidised lending remains significant, negatively affecting capital allocation and public finances and limiting the effectiveness of monetary policy, the EC said.

The share of subsidised corporate loans in total disbursements declined from 34% in 2023 to below 19% in 2024, as certain untargeted lending schemes that allowed for the refinancing of existing loans were phased out. Nevertheless, the share of subsidised loans remains elevated compared to the pre-COVID level of 7%.

These schemes can lead to suboptimal capital allocation by financing projects with low returns and limited productivity gains, this also limiting the transmission mechanism of monetary policy.

In its response to Portfolio's questions, the Commission also emphasised its belief that tax cuts, particularly corporate tax cuts, impact the Hungarian budget deficit. This has consistently exceeded the European framework's 3% of GDP reference value in recent years. The fiscal impact of tax cuts is particularly significant in this fiscal environment.

With regard to corporate tax benefits in the context of sports subsidies, it is noted that they have accounted for almost 0.2% of GDP in recent years. This could result in the inefficient allocation of resources, as companies may prioritise such donations over more productive investments in order to avoid taxation.

A Commission official added that the tax relief for under-25s is not targeted, as it applies to all workers in this age group regardless of their income level or occupation. He said he believed this could discourage participation in higher education by encouraging entry into the labour market. This would reduce the proportion of skilled workers in the long term and prevent workers from entering higher-prestige jobs. This could reduce the proportion of workers in higher-paying jobs, leading to a long-term decline in tax revenues while failing to significantly boost consumption.

Of course, the claim can be disputed. It is by no means certain that graduate positions pay better than unskilled jobs. Furthermore, reducing costs for young people could lead to them saving and entering the property market, as well as providing other social benefits.

More rigour would be warranted in some areas

The commission said environmental taxation could better internalise negative environmental costs. In other words, the tax system should enforce the 'polluter pays' principle more strongly.

The EC notes that in 2022, revenue from environment-related taxes was slightly below the EU average, at 1.9% of GDP. Still, Hungary’s tax revenues raised on energy and transport are below the EU average. While the environmental taxes on resources and pollution are above the EU average. There is room to increase environmental taxes to further internalise the cost of air pollution and to limit water pollution, for example on solid fuels like biomass in the residential sector, or on waste such as beverage containers.

The EU executive continues to think that the redistributive function of the labour tax system remains low. This is due to flat rate personal income tax system, with the taxation rate at 15%, and high reliance on flat-rate social contributions. Due to the lack of progressivity,

low-income earners are taxed relatively high - the tax wedge remains at the same level (41.2%) for different level income earners.

The highest in the EU VAT rate puts an additional burden on the low-income earners. More progressive labour tax system could increase the redistributive capacity of the tax system, while strengthening work incentives for low earners.

The EC also pointed out that the tax system does not address the high wealth concentration in Hungary.

The concentration of personal wealth in Hungary is the second highest in the EU

(with the top 1% share of taxpayers holding some 33.5% of total net personal wealth in 2022, as compared to the EU average of c. 25% in the same year) and has increased significantly since 2013 (from 25%

Another critical note is that currently, there is no net-wealth, nor exit tax for individuals in Hungary. The inheritance and gifts are taxed at an 18% rate, if the beneficiary is not a close relative, while residential property and rights with monetary value are subject to only a 9% rate.

Large exemptions substantially decrease the effective tax rates, including on

• inheritance of land suitable for constructing a residential property or inheritance of rights with monetary value on such land if the beneficiary builds a residential property on it within 4 years,
• inheritance of debt securities issued by a member state of the EEA; and
• estate inherited by descendants, ascendants or spouse of the deceased.

In the current context of heightened consolidation needs, the decline in tax revenue is constraining fiscal policy choices in Hungary,

the EC summed up Hungary's woes.

"The gradual decrease in the deficit in 2024 and in 2025 is expected to be mainly driven by decreases in interest payments and energy subsidies, cuts to public investments and temporary revenue from the windfall profit and sectoral taxes," it said

"To ensure that fiscal targets are achieved, Hungary will need to introduce permanent fiscal measures that do not undermine the growth potential of the economy."

Unless Hungary shores up tax revenue in a sustainable way, further fiscal adjustment is likely to disproportionately affect the expenditure side of the budget leading to cuts to growth-friendly expenditure, such as public investments and spending on essential public services

the Commission concluded.

Cover image (for illustration purposes only): Getty Images