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

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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

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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