Identifier
Created
Classification
Origin
08BUDAPEST1201
2008-12-17 08:44:00
UNCLASSIFIED//FOR OFFICIAL USE ONLY
Embassy Budapest
Cable title:  

ECONOMIC REFORM ISSUES I: THE TAX WEDGE

Tags:  ECON EFIN PREL HU 
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RR RUEHAG RUEHDF RUEHIK RUEHLZ RUEHROV RUEHSR
DE RUEHUP #1201/01 3520844
ZNR UUUUU ZZH
R 170844Z DEC 08
FM AMEMBASSY BUDAPEST
TO RUEHC/SECSTATE WASHDC 3699
RUCPDOC/DEPT OF COMMERCE WASHDC
RUEATRS/DEPT OF TREASURY WASHDC
INFO RUCNMEM/EU MEMBER STATES COLLECTIVE
UNCLAS SECTION 01 OF 02 BUDAPEST 001201 

SENSITIVE
SIPDIS

DEPT FOR EUR/CE, EB/OMA, INR/EC; USDOC FOR SAVICH; TREASURY
FOR ERIC MEYER, JEFF BAKER, LARRY NORTON; USEU FOR HAARSAGER

E.O. 12958: N/A
TAGS: ECON EFIN PREL HU
SUBJECT: ECONOMIC REFORM ISSUES I: THE TAX WEDGE

UNCLAS SECTION 01 OF 02 BUDAPEST 001201

SENSITIVE
SIPDIS

DEPT FOR EUR/CE, EB/OMA, INR/EC; USDOC FOR SAVICH; TREASURY
FOR ERIC MEYER, JEFF BAKER, LARRY NORTON; USEU FOR HAARSAGER

E.O. 12958: N/A
TAGS: ECON EFIN PREL HU
SUBJECT: ECONOMIC REFORM ISSUES I: THE TAX WEDGE


1. (U) This is the first in a series of reports on structural
economic reforms proposed by economists and macroeconomic
analysts to help Hungary achieve higher economic growth,
reduce macroeconomic vulnerabilities, and to remain
economically competitive in the region.

THE HIGH TAX BURDEN ON LABOR


2. (SBU) The high tax burden on labor often tops economists'
lists of areas in which structural economic reform is needed
in Hungary. Taxes on labor influence both workers' decisions
about how much labor they supply, and firms' decisions about
how much labor they employ. Critics complain that Hungary's
current labor tax rules discourage employment, encourage the
under-reporting of wages, and stifle the economic growth
potential of businesses. They assert that if not addressed,
Hungary will at best continue to be the economic laggard of
the region, or at worst, it could face a new financial or
economic crisis as investor confidence and Hungary's business
climate continues to erode.


3. (U) The OECD reports that the tax wedge in Hungary - the
difference between an employee's net take-home pay and the
cost of their employment, including income taxes and social
security contributions - is the second-highest in the OECD,
falling only behind Belgium. In 2007, single workers in
Hungary without children earning the average wage in services
and manufacturing industries faced a tax wedge of 54.4
percent of the cost of their labor. The average for OECD
countries was 37.7 percent.


4. (U) Although the personal income tax rate in Hungary is
not the highest in the EU (ranging between 18 and 40
percent),Hungary's large tax wedge also comes from employee
and employer contributions to the social welfare system.
Hungary's national bank agrees, noting that Hungary's high
labor burden for employers and employees is due to "extremely
huge social security contributions." In general, employers
pay approximately 29 percent of their employees' income for
pension and health care contributions, and individuals pay an
additional 17 percent.


5. (U) Worse still, the size of the tax wedge in Hungary is
growing. Between 2006 and 2007, the tax wedge in Hungary

grew more than in any other OECD country (2.5 percent). In
addition, the government is becoming increasingly reliant on
taxes on labor as a source of revenue, likely making future
reforms more difficult. Oriens Capital Investment notes that
the share of taxes on labor in the total government budget
increased from 45 percent in 2004 (as a percentage of total
government revenue) to nearly 50 percent in 2007.

DISCOURAGING EMPLOYMENT


6. (U) Economists point out that Hungary's high tax wedge
discourages employment, and that reducing it is critical to
increasing an employment rate which is among the lowest in
the OECD. According to March 2008 data, Hungary's labor
force participation rate for people age 15-64 was just 56.3
percent, well below the regional and OECD average of 70
percent. The IMF raised this issue in its latest Article IV
consultations, remarking that "a shift of the tax burden away
from labor and to consumption and wealth would improve work
incentives and boost employment." In a recent report, the
Hungarian National Bank recognized that the "large tax wedge
increases non-employment, or at least diminishes labor demand
and supply in the formal sectors." Increasing the level of
legal employment would generate additional government revenue
and help offset revenue lost through tax cuts.


7. (SBU) Hungary's tax laws also impose a high marginal cost
on employers who hire more than a certain number of
employees, discouraging the growth of companies in Hungary.
Combined with the overall high tax burden on labor, this has
had the effect in certain industries of promoting the use of
subcontractors or even illegal workers. In the construction
industry, for example, Oriens reports that the average
construction company in Hungary only employs three people,
whereas the Slovakian equivalent employs 19, and the average
Romanian construction company employs 13. Other analysts
point to these elements of the Hungarian tax system as the
reason why there are relatively few large-sized companies or
franchises of Hungarian origin.

UNDER-REPORTING OF WAGES


8. (U) It is also widely believed that Hungary's tax wedge

BUDAPEST 00001201 002 OF 002


not only overburdens those paying taxes, but also contributes
to the high level of tax evasion in Hungary (septel). Both
employers and employees have an incentive to underreport
their actual income. Estimates of illegal employment in
Hungary are among the highest in the EU. In 2004, income
produced by the illegally employed as a share of GDP was
estimated to be over 20 percent, and many believe the figure
to be as high as 30 percent. By contrast, the EU-15 average
was estimated to be 6.4 percent in the year 2000.


9. (U) The current labor tax system in Hungary also imposes
high marginal costs on raising salaries above a relatively
low level, which contributes to an under-reporting of income
(and subsequently a reduction in government revenue). Oriens
points out that under current tax rules, there is a
significant jump in the marginal costs to employers for
employees whose gross monthly incomes exceed HUF 150,000
(approx. USD 750). The steep increase in marginal costs at a
relatively low level (the current minimum wage is HUF 69,000
- approx. USD 345),encourages the non-reporting of income
above this rate.


10. (U) There is also a high marginal cost to employees as
the personal income tax rate in Hungary jumps from 18 percent
to 36 percent at a relatively low income level. Currently,
earnings below HUF 1,700,000 per year (Approx. USD 8,500) are
taxed at 18 percent, while earnings above this amount are
taxed at a rate of 36 percent. This creates an incentive to
report only those wages that fall within the 18 percent tax
bracket, and confirms the assertion of economists that tax
rates, when combined with corruption, exert a strong
influence on the size of the hidden economy.

REDUCING DEMAND


11. (SBU) The high tax wedge squeeze on households'
disposable incomes also has the effect of dampening consumer
demand, which is already suffering from the effects of the
global economic downturn and IMF/EU stabilization package
austerity measures. In Spring 2008, the "big four" tax firms
and the AmCham presented a series of tax proposals which they
believe would help boost economic growth, promote additional
employment, and help reduce the size of the informal economy.
The centerpiece of this proposal is a simplification of the
tax system, which would reduce the tax burden on labor, and
shrink marginal tax burdens. They believe the plan would
immediately result in an increase in GDP growth by 1 percent
over the current growth plan, and could result in a growth
rate of 4.5 percent within four years. Oriens believes
comparable results are achievable under its plan, which also
calls for the simplification of the tax system, and a shift
in the tax burden from labor to consumption.


12. (SBU) Comment. Although recognizing the problems high
labor taxes create in the economy, the GoH maintains that
significant tax cuts are not possible in the near term as it
focuses its attention on meeting deficit reduction targets of
the IMF/EU stabilization package. Many economists do not
believe, however, that tax cuts and fiscal consolidation are
mutually exclusive, maintaining that a reduction in the tax
wedge, offset by shifting some of the tax burden to
consumption, would not be an impediment to fiscal
consolidation efforts. They argue that a reduction in income
from lowering taxes on labor will be offset by increased
revenues resulting from higher growth rates and lower levels
of tax avoidance. End comment.
Foley