ECONOMIC REFORM ISSUES II: TAX EVASION AND THE

UNCLAS SECTION 01 OF 03 BUDAPEST 000006 SENSITIVE SIPDIS DEPT FOR EUR/CE, EB/OMA, INR/EC; USDOC FOR SAVICH; TREASURY FOR IRS, ERIC MEYER, JEFF BAKER, LARRY NORTON; USEU FOR HAARSAGER E.O. 12958: N/A TAGS: EFIN ECON PREL HU SUBJECT: ECONOMIC REFORM ISSUES II: TAX EVASION AND THE INFORMAL ECONOMY REF: BUDAPEST 12011 ¶1. (SBU) Summary. This is the second report on structural economic reforms economists and macroeconomic analysts believe are needed to help Hungary achieve higher economic growth, reduce macroeconomic vulnerabilities, and remain economically competitive in the region. The low tax compliance rate and large informal economy in Hungary undermines efforts to reduce the budget deficit and reduces the amount of funding available for public services. To address this problem, the tax authority is focusing its efforts on strengthening enforcement measures and increasing public awareness of the role of taxes in society. Many believe that more comprehensive tax reform is needed to address the underlying causes of Hungary's low tax compliance rate, and that without reform, the situation will only marginally improve. End summary. TAX EVASION AND THE INFORMAL ECONOMY IN HUNGARY ¶2. (SBU) Tax evasion and avoidance is a serious problem in Hungary, compounding the country's large budget deficit and national debt problems by reducing the amount of government revenue. The OECD notes that despite some recent improvements, "Hungary suffers from poor tax compliance, resulting in significant revenue leakage." As noted reftel, the number of people working in the informal economic sector in Hungary is among the highest in the EU. Although accurate statistics are difficult to obtain, the most commonly cited estimate is that income produced by the illegally employed makes up more than 20 percent of Hungary's GDP. By contrast, the EU-15 average was estimated to be 6.4 percent in the year ¶2000. In 2006, the size of the hidden economy in Hungary was estimated to be around HUF 4,000 billion (USD 20 billion),of which HUF 1,000 billion (USD 5 billion) would have contributed to the central budget. ¶3. (SBU) The 20 percent estimate matches what Hungarian Academy of Sciences economist Janos Kollo calls the "first guesstimate of gray economic activity in the 1980's." Ecostat official Belyo Pal notes that in the 1980's, however, the backbone of the shadow economy in Hungary was the unofficial business activity of private individuals, but that from the 1990's, tax evasion and unregistered business activities of enterprises were the key factors in the hidden economy. Areas where businesses are commonly reported to abuse the system include the employment of unregistered workers and the use of fraudulent accounting practices (fictitious invoices, hidden petty cash, carouseling invoices, etc). Although only 46 percent of company managers admitted to the existence of a black market in a recent Ecostat poll, of this number, over 40 percent admitted to having unregistered employees. Another common way in which companies reportedly avoid paying taxes is by paying their employees the monthly minimum wage of HUF 69,000 (approx. USD 350) and then supplementing it with under the table payments or by refunding VAT receipts for goods bought by employees in the company's name. ¶4. (SBU) Lost tax revenue not only impacts the Hungarian government, but those relying on government services as well. Hungary is currently subject to EU excessive deficit procedures, and for the past two years, the country's macroeconomic policy has been focused on fiscal consolidation. High levels of tax evasion and avoidance undermine this objective by reducing the level of revenue coming into state coffers and making it more difficult for the government to provide important services to citizens. A large informal economy also skews Hungary's official employment rate statistics, giving the appearance of a less active population than is actually the case. WHY IS TAX EVASION AND AVOIDANCE SO HIGH? ¶5. (SBU) Although tax compliance issues exist in every country, economists and other observers suggest a number of reasons why levels of tax evasion and avoidance are particularly high in Hungary, including: ECONOMIC NEED. The average person would likely cite economic necessity as the main reason Hungarians cheat on their taxes. Many maintain that low wages coupled with a high cost of living and high tax rates make tax evasion an unavoidable reality for many people. The same is often said for small businesses, which many argue are "driven into the gray BUDAPEST 00000006 002 OF 003 economy" by high taxes, and that unless they find some way to avoid paying taxes, many would lose economic viability and be forced to close. POLITICAL DISSATISFACTION. Another common explanation for high levels of tax avoidance is that there is a high level of distrust of the government, and many do not believe the government will use taxpayer money responsibly or in a manner consistent with their views on how public resources should be allocated. Whether true or not, it is widely believed that revenue generated through taxes is either wasted, misallocated, or even pilfered by unscrupulous politicians. STRUCTURAL DISINCENTIVES. As noted reftel, Hungary's current income tax rate structure, with steep jumps between tax brackets, creates incentives for the underreporting of income. GKI Research Institute Deputy CEO Gabor Karsai notes that the taxation system of employment makes the employment of people with medium or higher qualifications "astonishingly expensive," and is "both a reason and a consequence for the widespread gray and black labor market." In addition, the narrow gap between the minimum wage and the amount that can be received through the social welfare system creates an incentive to work on the informal economy while continuing to collect social welfare benefits. Ironically, contacts in the civil sphere admit that this phenomenon extends even to NGOs, where officials are often dual-hatted...and double-dipping. HISTORICAL TRENDS/TAX MORALITY. Debrecen University professor Dr. Tibor Glant argues that the economic liberalization of the 1980's, while allowing limited private enterprise, also encouraged the growth of the hidden and informal economy, as uncertainty regarding the government's commitment to market-oriented reforms caused many to keep private economic activity out of sight of the government. If true, the market-oriented reforms that gave Hungary a head-start in the region following Hungary's transition to a Western-style parliamentary democracy may be contributing to the large informal economy in Hungary today. Others argue that Hungary's tradition of tax avoidance dates back even further to the Austro-Hungarian empire, when Hungary was required to pay taxes to the monarchy in Vienna. Prime Minister Gyurcsany himself has commented privately that Hungary has yet to overcome the mindset that "taxes have always paid for foreign occupation so tax evasion has always been a patriotic duty." WEAKNESSES IN TAX ADMINISTRATION. Still others argue that people avoid paying taxes simply because they are able to get away with it. Miklos Kok of Hungary's tax administration (APEH),quipped that there "is no limit to the creativity of the Hungarian people in finding ways to avoid paying taxes." He notes that today it is even considered "fashionable" by many to avoid paying taxes. According to Kok, the major thrust of APEH's efforts to improve tax compliance is to close loopholes and increase the penalties for intentional tax evaders (see below). COMPLICATED TAX SYSTEM. APEH officials admit that Hungary's complicated tax system leads to a fairly high level of unintentional underreporting of income. As FIDESZ Party President Viktor Orban recently vented, "I have only my salary - so why should I need an accountant?" The government is working to address this both through a simplification of the tax rules, as well as through tools to assist taxpayers in better understanding tax laws. GOVERNMENT RESPONSE: EDUCATE THE PUBLIC AND CARRY A BIG STICK ¶6. (U) The government's primary response to the problem of tax evasion and avoidance has been to increase and improve its investigative capacity and to increase civil and criminal penalties for tax evaders. In recent years APEH has increased the number of checks on individuals' income tax declarations, and has hired more labor inspectors to check salary arrangements. Hungary's recently passed 2009 tax package includes higher penalties and new compliance requirements. APEH officials tell us there is an increased focus on risk assessment, and that audits and labor inspections are now being carried out in a more targeted way. There has also been a growing use of indirect tools, including the use of minimum tax rules. For example, in 2006, Hungary set a "double minimum wage rule" whereby employers are required to pay contributions on double the minimum wage unless they can prove the employee is paid less BUDAPEST 00000006 003 OF 003 than this amount. The government has also announced a "tax lottery" to encourage people to request VAT receipts in order to increase VAT compliance rates. ¶7. (U) Although many complain that the government is too heavily focused on the enforcement of tax rules and not on positive incentives like tax relief and the simplification of tax rules, increased enforcement has had some success. In 2007, the increased investigative capacities of the tax authorities on wealth statuses and personal income tax declarations reportedly resulted in extra tax revenues of approximately 0.3 percent of GDP. ¶8. (U) Economists caution, however, that exclusively focusing on strengthening enforcement could result in reduced disposable income for individuals and higher labor costs for businesses, which in turn could affect levels of consumption, exports, and growth. The OECD agrees that punitive measures can only be successful to a point, noting that "while efforts to reduce tax evasion and strengthen tax administration and collection have yielded positive results and should be continued," the prospects for further reducing the gray economy "would seem to require a substantial reduction of the tax wedge on labor." ¶9. (U) APEH officials admit that enforcement alone is not enough, and have increased efforts to educate the public on the role of taxes in society through public school and direct media campaigns. In addition, APEH is trying to become more customer service oriented by simplifying the tax paying process and reducing the administrative burden on taxpayers. A DIFFICULT ROAD AHEAD ¶10. (SBU) Comment. Having undergone a significant restructuring in 2007, in which 23 district tax offices were consolidated in 7 tax directorates, APEH is quickly improving its enforcement capacity, resulting in improved compliance rates and higher revenue for the state. But the system they are enforcing remains inordinately complicated, and the organization's attempts to win over the hearts and minds of a skeptical population that believes it is paying more into the system than it is getting out of it have not been as successful. Internal scandals and embarrassments have not helped APEH'S public image either, and have undermined both objectives. For example, in September a senior APEH inspector was arrested on suspicion of receiving bribes in exchange for providing favorable results on wealth inspection reports. In addition, the tax authority was the subject of much public jesting in November when it announced it would not hire new workers with an IQ of less than 90 (the average human possesses an IQ of 100). ¶11. (SBU) Comment continued. Although many welcome GoH public outreach efforts to educate the public and help increase public willingness to pay taxes, they believe the Government's focus on stricter enforcement can only go so far in reducing the size of the informal economy. The key, they believe, is to overhaul the tax system by simplifying tax regulations, reducing the tax burden and making it more equitable, and reducing the marginal differences between tax brackets. Until this happens, however, a significant share of potential tax revenue will continue to be lost to the gray economy. End comment. Foley