Economics Department

Economic Survey - Hungary 2004: Macroeconomic Policy

 

Fiscal policy: what are the problems and prospects?

The general government deficit for 2002 overshot the initially approved deficit by a wide margin, coming in at 9.2 per cent of GDP on an accrual basis. To some extent this outcome reflects one-off factors worth about 3 per cent of GDP, in particular the incorporation into the budget of previously accumulated large quasi-fiscal debts relating to motorway construction. However, the large deficit was also due to overspending in almost all categories of expenditure in anticipation of local and general elections. The 2003 deficit, estimated in early 2004 to be 5.6 per cent of GDP, marks an improvement, especially in view of the difficult international environment But, in order to reach sustainable public financing and to comply with the Maastricht criteria for EMU entry in 2008, the general government deficit will have to be reduced to 3 per cent of GDP by 2006 through savings on the expenditure side. This further adjustment will be much more difficult as the easy measures have been taken. The 2004 budget envisages deficit reduction to 3.8 per cent of GDP (ESA95 basis). This is mainly brought about through increased revenue, rather than significant expenditure cuts. The relatively small expenditure cuts are due to accelerated investment in motorway construction, EU-accession related spending and the fact that achieving substantial saving in structural expenditure takes time. Given the already high taxburden, its further increase next year is not helpful for growth. At the same time, there are useful moves in specific revenue and spending areas that could give rise to wider and substantial expenditure reductions. Following-up on measures taken in 2003, there is to be further narrowing of eligibility and reduced generosity in the housing-loan subsidy scheme. Also a cut of ten per cent in central government employment (around 7 000 employees) is scheduled for 2004. Though this is a small reduction in the approximately 821 000 public-sector employees, further cuts in employment may arise from tightening wage-related transfers from central budget to other areas of government.

 

Government spending


Source:   OECD Economic Outlook, Analytical database; revised GFS accounts.


How to make deficit reduction sustainable?

If Hungary is to comply in a sustainable way with euro-area membership criteria, budget consolidation from the expenditure side has to start now. Given development and implementation lags, the efficient continuation of budget consolidation in 2005 and beyond requires that work should begin now on the
key elements of a medium-term fiscal strategy that:

  • encompasses appropriate measures to broaden the tax base and lower rates where possible, 
  • strengthens budgetary procedures to assure that the longer-run implications of spending decisions are clearly identified and to promote value-for-money through output-oriented financing and performance benchmarks, 
  • and identifies structural measures to reign in the growth of spending across the full range of government programmes.

The scope for achieving deficit reduction through revenue enhancement seems exhausted. While efforts made over recent years to reduce tax evasion and strengthen tax administration and collection have yielded positive results and should be continued, the prospects for further reducing the grey economy and thereby enlarging the tax base would seem to require a substantial reduction of the tax-wedge on labour.  While such a reduction is highly desirable on structural grounds, the trade off in revenue terms is almost surely negative, at least in the short term. At the same time, pressures to reduce business taxation will remain strong.  Nonetheless there are a number of base-broadening measures the government should explore:

  • The taxation of capital income varies widely across income types and in some cases is very lenient. Most notably, interest income, currently taxed at a zero rate, should become subject to some taxation once disinflation has progressed sufficiently.
  • The system of income tax credits and allowances should also be reviewed. In particular the allowance on housing loans should be further cut back and family tax credits should focus more on increasing female labour force participation.
  • There remains scope for broadening value added tax.
  • Finally, local governments should be encouraged to make more use of the available opportunities for residential property taxation.

Overall, given the already high tax burden, the role of tax reform should be to improve efficiency and reduce the most damaging distortions in the system, while budget consolidation should be pursued primarily on the expenditure side.

A strategic, medium term framework to quicken expenditure reform is essential, and requires not only systematic review and prioritisation among central government programmes with a view to higher efficiency, but also an enhanced local government involvement and responsibility for achieving fiscal policy targets and adopting udget reforms. Specific issues to be examined include:

  • Already in 2004, the planned cuts in public sector employment need to be linked to administrativereforms and targeted on lower-priority activities rather than being implemented across the board. The logic of the substantial pay increases awarded in the public sector in the last couple of years, 50 per cent for most employees, was to create the basis for a smaller, more productive public administration, which needs to be implemented. 
  • The 1998 pension reform foresaw a progressive reduction in spending on first-pillar benefits with a view to assuring the sustainability of the system. The logic of this reform should be restored, and the decision to introduce a  thirteenth month to pensions should be reconsidered. 
  • While, overall, replacement rate levels in social transfer programmes are not very high in international terms, their coverage is very wide. In view of Hungary’s low participation rate, careful re-design of these programs, as further discussed below, could both reduce spending pressures and improve work incentives.


Monetary policy: how big are the challenges in the run-up to adopting the euro?

The transition from a crawling-peg to an inflation-targeting regime was achieved smoothly and initially the new regime appeared to be working well. However, monetary policy has recently faced some difficult challenges, including speculative attacks on the currency. These events partly reflect a concern that monetary policy is overburdened, since that involves not only achieving inflation targets but also stabilising the exchange rate within a narrow band which is considered to be compatible with inflation objectives and contribute to a smooth entry to ERM II and the euro area. There is nevertheless a risk that market conditions will make these goals incompatible. Given this problem, the Central Bank’s policy of pursuing a nuanced communication strategy that includes reference to an exchange rate objective seems appropriate but risks attracting speculative attack if a lot of
detail on the willingness to defend the exchange rate target is made in public.

Particularly in late 2002 and in the beginning of 2003, there was discordant public debate between the Central Bank and the government, threatening the credibility of macroeconomic policy in the eyes of the markets. Since then, substantial efforts have been made for more visible, as well as substantive, consensus. It is important that the authorities maintain these efforts, particularly in light of the ambitious deficit and inflation targets for euro entry. Responding to some inflationary revenue increases in the 2004 budget, the Bank, in agreement with the government, has set an inflation target of 4 ±1 per cent for December 2005, half a percentage above that for the end of 2004 though still incorporating within the band the 3 per cent expected to be sufficient for euro entry. If fiscal policy goals are fully met, the jointly set inflation target may be reached without further monetary tightening.  Nevertheless, if need be, a final push to the inflation rate required to fulfil the convergence criteria can be made in the final run-up to the 12-month assessment period. This strategy is not without risks. Adoption of the euro in early 2008 would require a positive convergence assessment which in the case of the inflation criterion would be based on a 12-month assessment period starting somewhere in 2006. It will thus be important to communicate in a credible way that the Bank would respond to a prolonged pause in disinflation with an appropriate tightening in monetary conditions. As noted, support from a fiscal strategy based on expenditure restraint will be necessary.  Clearly, failure of fiscal policy to achieve the targets set for it would compromise both the credibility of the nominal convergence strategy and the coherence between inflation and exchange-rate objectives.

 

Inflation, exchanges rate and interest rates

1. Core index, computed by the Central Statistical Office.

2. Twelve month interest rate deflated by expected inflation derived from Reuters poll.

Source:   OECD; Central Statistical Office and National Bank of Hungary.

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The complete version of the OECD Economic Survey for Hungary is available from :

 

Return to the OECD Economic Survey - Hungary 2004 homepage

 

 

 

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