Economics Department

Economic Survey - Hungary 2004: Structural policies to foster growth

 

What policies are needed to improve wage setting?

Wage setting is crucially important for competitiveness and price stability. In recent years private sector real wage growth has been strong, though less so in 2003. The substantial fall in inflation from mid- 2001 appeared to have had a delayed impact on the rate of nominal wage increases. Hikes in the minimum wage led to increases among the low-paid and likely had a ripple effect on wages above the minimum. In addition, a succession of large increases in public sector pay between 2001 and 2003 has had demonstration effects on private-sector pay increases and may have tightened supply for certain types of labour to the private sector. The challenge for wage determination in the years ahead is twofold: first, the wage increases that have been well above average productivity gains will have to be clawed back to some extent in order to restore a wage level which is compatible with international competitiveness, and second, nominal wage rises will have to appropriately incorporate the sharp disinflation that will be achieved, one way or another, on the way into the euro zone. Wage policy for 2004 reflects these aims and includes reverting to indicative wage guidelines in gross nominal (rather than net real) terms. This practice should be continued.

How to bring more people into regular employment?

The delayed reaction of nominal wages to falling price inflation suggests that inflation expectations have not yet fully incorporated actual developments. The lagged nominal wage response also points to tight labour markets in leading sectors and for certain skills in the central-western part of the country. This further underscores the need to implement policies that bring more of the non-employed into work. To some extent this is a regional issue, which has to be addressed by increasing labour mobility on the one hand and broadening job creation across the whole country on the other. More generally, formal employment is restricted by the high tax wedge on working, espe- cially for the low-paid. Some social benefit programmes, like the disability scheme and family benefits, have become an effective route to leaving the labour force. Such an environment is also not conducive to human capital accumulation necessary to secure employability on the official labour market.

While there have been encouraging, though slight, increases in labour force articipation and employment rates in recent times, levels remain well below leading countries in this regard. While considerable reductions in the tax wedge have been made in recent years, further reductions are still needed. These should incorporate a focus on improving incentives for creating and taking up jobs with skill requirements appropriate for the inactive population. The taxwedge reductions should also increase incentives to take up official employment so as to reduce greysector activity and widen the tax-base. The shift to exempt the minimum wage from income tax further bolsters incentives to join the labour force and measures should now focus on reducing the substantial employer contributions for low-paid workers in order to boost demand. In particular, the fixed component of the employers’ contribution to health care adds excessively to labour costs at the low end of the job market and contributed to the poor development of part-time work. The authorities have decided to exempt this payment for certain groups, including certain categories of part-time workers and should aim to advance the complete phasing out of this fixed contribution from its envisaged date of 2006.

The increases in the statutory retirement age and significant tightening of access to early-retirement schemes were implemented effectively, reduced withdrawal from the labour market and have played an important role in encouraging recent improvement in the employment rate among older workers. And the full effect of the reform has yet to be realised as old schemes were grandfathered. However, as in other countries which have sought to restrict early retirement, Hungary has experienced a concomitant increase in the number of persons on disability benefits. Reforms to this system are needed and should introduce a more thorough assessment of the remaining capabilities of workers and promote their reintegration in the labour market through rehabilitation measures and in-work training.

Support for child care is largely in the form of cash benefits and family tax credits. Although participation of prime-age women in the labour market is roughly similar to the OECD average, further improvements in the relevant policy areas should be sought. In addition, state-supported child care services vary widely across local authorities but are in general limited. The possibility of three years parental leave may distance parents from the workforce, increasing the chances that they will not take the option of returning to their jobs and risking poor progress in professional terms if they do. With these issues in mind, the authorities should consider ways of re-balancing the package of child care support to provide less cash, but more child care services either directly, or by subsidising private-sector child-care for working families so as to make work a more attractive option.

Regional labour-market imbalances are accentuated by the “lock-in” effect on labour mobility generated by the combination of a small market for rental housing and high home ownership in all parts of the country. The enormous differences in house prices across regions reflect, at least in part, the impact of taxbreaks and non-transferable subsidies to home ownership which essentially impact on the property market in the west of the country. The recent reductions in the scope and generosity of the housing-loan subsidy scheme may help to reduce the bias in favour of home-ownership, and prevent a further regional widening of house price differences. Further downsizing of the scheme is needed and it should eventually be abolished. The tax-breaks on mortgage interest and capital repayments also favour buying rather than renting. At a minimum, the tax breaks should only be on interest payments and the authorities should seriously consider whether the welfare objectives of the breaks could not be better achieved in other ways. Expanding the dynamics of job creation throughout the country might be assisted by allowing local labour market conditions to be fully reflected in wages as well as by improving infrastructure so as to broaden the location of investment.

How to get good results from the big investment planned for transport?

The density and quality of long-distance road and rail transport influences firms’ location decisions, contributing to the large regional differences in economic development. In addition, poor short-distance transport in many areas limits commuting possibilities. Thus, local labour markets are often small and this contributes to demand-supply imbalance and unemployment within regions. The substantial increase in resources allocated for road infrastructure in the 2004 budget submission is a welcome move to reduce regional disparities, as the main priority of road construction is to more closely link peripheral and less developed parts of the country to the more economically successful regions. In this environment of accelerated spending the authorities are urged to strive for greater efficiency in outcomes by increasing the role of cost-benefit studies in the decision making process. Steps in this direction have been taken recently to ensure that decisions are not excessively biased towards “glamorous” projects for new motorways over small-scale road-building and maintenance. In rail services, modernisation clearly needs major investment. This should be driven by further progress towards liberalisation, including the introduction of a fully independent network operator.

Are the right policies in place to encourage domestic and foreign investors?

Hungary has made considerable efforts to establish a business friendly regulatory environment from the outset of the transition process and the high rate of FDI and enterprise creation is a positive reward in this regard. However there are outstanding issues, ranging from a need for better co-ordination between central and local tax authorities to strengthening competition and regulation in network industries and especially the part of the Hungarian economy serving the domestic market. There is also considerable scope for efficiency improvement by cutting back subsidy programmes for a wide range of activities. A fundamental issue concerns the accountability and de facto independence of regulators. In particular, legislation presented to parliament should be used as an opportunity to strengthen these in the area of financial supervision. While the legislation aims to strengthen accountability vis-a-vis the Ministry of Finance, it is accepted among OECD countries that financial supervisors should have the operational independence required to carry out supervision of financial institutions and markets autonomously.

In business taxation, the impact of the low corporate tax rate in making Hungary attractive for investment is weakened by the inappropriate base of the local business tax. More generally, there is a lack of stability to the tax system due to frequent changes, making compliance difficult and adding to administrative burdens. Local taxation on non-residential property also has an inappropriate base. Recent changes in business taxation are aimed to mitigate these problems, however further reform is necessary.  The banking sector dominates Hungary’s financial system, with capital markets playing a less important role. Recent trends in the efficiency and profitability indicators of the banking sector bode well for future financial stability, although part of the buoyancy in the sector is related to subsidised loans, in particular the housing subsidy and, to a lesser extent, the various loan and credit subsidies for SMEs. The authorities should make a general evaluation of how much subsidy support is leaking into the financial sector and take a close look at the design of all relevant schemes.

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