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ACCEPTANCE SPEECH AT THE HUNGARIAN ACADEMY OF SCIENCES

ÁDÁM TÖRÖK: Science or competitiveness? Science and competitiveness! ______557

PUBLIC FINANCESMONETARY AND FISCAL SYSTEM

GUSZTÁV BÁGER – GYULA PULAY: Major conclusions from the macroeconomic risk analysis of the 2009 budget bill ____________________________________580

LÁSZLÓ CSABA: The new kind of macroeconomic populism __________________601

GYULA NAGY: Role of financial innovations in oligopolistic market environment ______________________________________________________617

ÁDÁM DEMÉNY: The central budget management system and the impact thereof __________________________________________________________633

TAXATION AND THE TAX SYSTEM

ZOLTÁN PITTI: The operational efficiency of the fiscal system in terms of key tax and contribution liabilities __________________________________645

ZOLTÁN LÓRÁNT: Local public finance and local taxes ________________________656

JÓZSEF PAPP: Freeing the hamstrung economy ______________________________675

KATALIN SOLT: The application of welfare economics to taxation ______________708

LÁSZLÓ KLICSU: Sustainable society – flat tax ______________________________721

BIBLIOGRAPHY REVIEWBOOKS

PÉTER MIHÁLYI: Why is the Hungarian economy poorly?(György Szakolczai) ________________________________________________738

MIHÁLY SIMAI: The world economy in the vortex of the 21st century (Tamás Halm)______________________________________________________753

LÁSZLÓ PRÁGER: Within and beyond global economy (Gyula Pulay)____________759

ISTVÁN BENCZES: Trimming the sails (István Magas) ________________________764

ANDRÁS VIGVÁRI: Financial system. A non-mainstream approach(Péter Galbács) ____________________________________________________770

PUBLIC FINANCE QUARTERLY

Journal of Public FinancePublished Quarterly

Founder and Owner: Ministry of Finance, Hungary, since May 1954State Audit Office, Hungary, since July 2005

The purpose of this journal is to present an authentic picture of the domestic financial system in Hungary, to show the major features of operating

the public sector and the national economy – as reflected by the principal financial interactions –, the efforts aimed at convergence and at building a future, as well as presenting

the related professional debates.

EDITORIAL COMMITTEE

László Akar, László György Asztalos, Henrik Auth, Gusztáv Báger, Péter Ákos Bod, Katalin Botos, Attila Chikán, Pál Csapodi (Editor-in-Chief), Tamás Erdei (Co-President), Károly Fazekas,

Erzsébet Gidai , Tamás Halm, István Hetényi, Tamás Katona, Lajos Kósa, Árpád Kovács (President), Mihály Kupa, Tamás Mészáros, Zoltán Nagy, Éva Palócz, László Parragh, József Roóz,

Iván Schweitzer, Péter Székely, Elemér Terták, Ádám Török (Co-President), Mihály Varga, József Veress, Éva Voszka

EDITOR STAFF

Pál Csapodi (Editor-in-Chief), János Lévai (Senior Editor), László György Asztalos, Gusztáv Báger, Tamás Halm, Iván Schweitzer, Ádám Török (Head Columnists),

Ildikó Nagy (Editor), Pálné Görgényi (Proof-Reader), Éva Palló (Layout Editor)

Public Finance Quarterly publishes articles proofread by editorial committee members holding scientific degrees.

No part of this publication may be reproduced or distributed for commercial use in any form or by any means without the prior permission of the Publisher.

Public Finance Quarterly – Journal of Public Finance Editorial Office: 1052 Budapest, Bécsi u. 5., Phone: 484-9104, 235-4075,e-mail address: [email protected] Translation: L.C. Bt. Publishing House of Hungarian Official Gazettes, 1085 Budapest, Somogyi Béla u. 6., Phone: 266-9290 Responsible Publisher: dr. László Kodela, Chief Executive Officer of the Publishing House of Hungarian Official Gazettes. Printed by: The printing House of the Publishing House of HungarianOfficial Gazettes; Responsible Executive Norbert Burján, Executive Officer. HU ISSN 0031-496-X., www.hknyomda.hu

Price: HUF 5,775

Authors of this Issue

GUSZTÁV BÁGER

Ph.D. in Economics, Professor Emeritus, Pázmány Péter Catholic University,Scientific Consultant, Research and Development Institute of the State Audit Office

LÁSZLÓ CSABA

Correspondent Member of the Hungarian Academy of Sciences,University Professor, Central European University, University of Debrecen,Budapest Corvinus University,

ÁDÁM DEMÉNY

Economic Director, IT Service Centre of the Ministry of Finance,Ph.D. student, Zrínyi Miklós University of Defence

PÉTER GALBÁCS

Ph.D. student, University of Miskolc

TAMÁS HALM

Secretary General, Economic and Social Council,Secretary General, Hungarian Economic Society

LÁSZLÓ KLICSU

Assistant Professor, Ph.D. student, Pázmány Péter Catholic University

ZOLTÁN LÓRÁNT

Director General, State Audit Office of Hungary,Titulary College Professor, University of West Hungary,Titulary College Associate Professor, Budapest Business School

ISTVÁN MAGAS

Ph.D. in Economics,University Professor, Budapest Corvinus University

GYULA NAGY

College Associate Professor, College of Modern Business Studies,Ph.D. student, Széchenyi István University

JÓZSEF PAPP

Associate Professor, Budapest Corvinus University

ZOLTÁN PITTI

Scientific researcher, Budapest Corvinus University

GYULA PULAY

Ph.D. in Economics,Assistant Professor, Semmelweis University,Director General, Research and Development Institute of the State AuditOffice

KATALIN SOLT

Ph.D. in Economics, Associate Professor, Széchenyi István University

GYÖRGY SZAKOLCZAI

Doctor Habilitus,Professor Emeritus, Budapest College of Management

ÁDÁM TÖRÖK

Ordinary member of the Hungarian Academy of Sciences, University Professor, Pannon University, Budapest University ofTechnology and Economics,Editor-in-Chief, Acta Oeconomica


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Ádám Török*

Science or competitiveness?Science and competitiveness!Acceptance speech at the Hungarian Academy of Sciences

AIn economic political debates, it has beenendeavoured increasingly frequently inHungary since 2002 to reassess the economicrole of each sector. Attempts to relieve thestate budget affect a broadening range of pub-lic services, and standpoints more on the radi-cal side doubt justification for state financingeven in case of previously consensual publicservices. Reassessment of the state's functionsand duties is particularly observable in sectorswhere the link between financing and output isindirect, or where the social benefit of output isonly partially or not at all measurable in pecu-niary terms. It is a natural aspiration not toprovide more abundant funding to the welfarestate than what is affordable and matches thedevelopment level of the respective economy.However, sectors that do not just “swallow”money without any short-term or long-termsocial benefits, but provide services that arenecessary for the future development of theeconomy cannot be considered to be a part ofthe welfare system. This includes education,healthcare and, most particularly, an indistinctarea that is sometimes referred to as science, or

as research and development (R&D), or, atother times, as the national system of innova-tion (NIS).

The abovementioned debates over economicpolicy have not spared this area, either. Varioussurveys have been produced of the HungarianR&D sector or the national system of innova-tion since the early 90s1. Most of these clearlyrevealed that only a small portion of theamounts provided to Hungarian research anddevelopment institutions was returned in theform of innovative products and services thatproved competitive on the market. The factsrevealed by the researchers could justly beinterpreted to say that Hungarian R&D is pur-sued detached from the economy, mostly defy-ing the needs of the economy, and it only fol-lows its own goals interpreted in the narrowsense (scientific excellence, academic progress,international success in applications for funds).If one attempts to evaluate the functioning andperformance of the Hungarian R&D sectorfrom the aspect of competitiveness, the conclu-sions can be expressed in two distinct state-ments, as follows:

The Hungarian R&D sector alone is notsufficiently competitive.

The Hungarian R&D sector does not suf-ficiently contribute to increasing the competi-tiveness of the economy.

* The author wishes to thank Gyöngyi Csuka, ZsuzsaDeli-Gray and Kitti Schwartz for their help andadvice, and takes full responsibility for any errors andinaccuracies.


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The present study will assess these latter twotheses, which were also voiced frequently in theHungarian government communicationbetween 2004 and 2007, and an attempt will bemade to interpret them more in-depth. We areinterested in the bilateral relationship betweencompetitiveness and R&D, a mutual linkbetween an important measurement of eco-nomic performance and probably the mostimportant field in creating knowledge, so faronly partially explored in the literature.

ABOUT VARIOUS INTERPRETATIONS OFCOMPETITIVENESS

Competitiveness has become a catchword inmodern economics, and besides, it has alsogained ground as a political talking point. Witheconomic science split into two major branch-es, theoretical and applied economics, asopposed to business/management studies, nowfull-fledged disciplines, competitivenessresearch has been assigned to the latter area. Itmostly entails corporate competitivenessresearch, while the analysis of the competitive-ness of national economies has ended up in akind of no-man's-land between theoretical(macroeconomic) and business/managementresearch. A typical standpoint, although farfrom exclusive in the field of economics, is rep-resented by Paul Krugman (Krugman, 1994;Krugman – Obstfeld, 2003), who definitelyrejects any interpretation of the notion ofcompetitiveness at the macro level.2

Krugman's sharp counter-opinion is partlyrooted in his observation that economic rela-tions among countries rely on cooperation atleast as much as on competition, but he alsopoints out that the operation of multinationalcompanies widens the gap between measuringcorporate performance and that of the nationaleconomy. This objection is valid in itself, but itignores the fact that measuring trade benefits is

traditionally applied to business premises andnot to companies (since Smith, Ricardo, Milland the Heckscher–Ohlin-theory), and thisapproach is also adopted by international tradestatistics.

The notional and theoretical basics of com-petitiveness analyses are still unclear frommany aspects. At first sight, “coping with com-petition” could be a spoken language synonymto the notion of competitiveness, but – surpris-ingly to certain economists – there is no gener-ally accepted definition of competition as thebasic category of market economy. This ismeaningfully pointed out by Robert Bork in hisfundamental work on the theory of competi-tive policy, who lists no fewer than five diverseinterpretations of competition (Bork, 1993)3.On interpreting competition or, for that mat-ter, competitiveness, it does make a differencewhich understanding is used as the startingpoint, but, unfortunately, no general agreementhas been reached on this issue within the trade.This results in the fact that competitive analy-ses – particularly at the macro and sectoral lev-els – are actually produced without a solid the-oretical foundation for the time being.4

In the absence of a theoretical background tothe notion of competitiveness, a (lesser for-malised) methodological framework toanalysing competitiveness has evolved, which isconsidered for the majority of macroeconomicor sectoral investigations.5 The first key issuehere is the measure i.e. whether the competi-tiveness of market actors is measured againsttheir own abilities or the competitors' perform-ance. It is possible for a competitor to highlyoutperform their own abilities, and still be alaggard in the international field. The literatureabounds in competitiveness measurementsbuilt on international comparison, but we willsee that in certain cases – particularly forapproaches concerning the supply side – mar-ket actors' own abilities are also considered.

In terms of methodology, competitive-


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ness analyses at the macroeconomic or sectorallevel (especially international analyses) can beclassified in three groups (Török, 2006a). Thepoint of approaches concerning the supply sideis that countries in a more favourable supplyposition (for example, producing at lowerwages or other cost advantages) are consideredmore competitive, because on a ceteris paribusbasis we believe that cost advantages lay theground for better market performance. Theseapproaches are in line with practical experiencemostly on price-sensitive markets, but wheredifferentiated products attempt to acquire cus-tomers not only through prices but alsothrough various special parameters and servic-es, they are less applicable to actual marketcompetition. This approach is representedwhen an explanation is sought for the goodperformance of “low wage countries” (or a lessclear correspondence with “newly industrial-ized countries” (NIC) – “tigers”] in terms offoreign direct investment or commodityexports).

The demand side approach is just theopposite of the previous one. It is not the costfactors of foreign economy that count, but per-formance itself, which can be measuredthrough export growth or market share.Improved competitiveness on the demand side,however, can be apparent or temporary, if, forinstance, market share only grew as a result ofa competitor's elimination, or if temporaryexchange rate changes are underlying a rise inthe market share. In practice, it is not at all cer-tain that the dynamics of competitiveness onthe demand and supply sides are closely con-nected for a market actor, and this is why soleapplication of either of these approaches mustbe considered as one-sided, and, in specificcases, causing distortion.

The third approach is comprehensive innature, and does not directly represent a meas-ure of coping with international competition.Competitiveness here is regarded as a general

indicator of the economy's state, assuming thatan economy that can be described by betterindicators is more competitive. More devel-oped, faster growing economies that createmore jobs and have better balance indicatorsprobably have better abilities to exploit theirresources efficiently. This is the approachadopted for international country lists of com-petitiveness, such as the rankings regularlypublished on an annual basis by WorldEconomic Forum or IMD.

The three approaches presented may equallybe used on examining the competitiveness ofscience, R&D and innovation, as well as theirimpacts on competitiveness. Before that, it isworth clarifying the notions here.

SCIENCE, R&D AND INNOVATION

Creating, organising and using knowledge foreconomic purposes (more accurately: adaptingfor use for economic purposes) are three fieldsthat can easily get mixed up. The boundariesare fuzzy because a senior research fellow at aresearch institution or an associate professor(similarly to their associates in other ranks)may perform scientific, R&D and innovativeactivities simultaneously, even literally at thesame moment. Scientific results in general –unless they are a result of divine intuition,which has been diminishing since the early 20thcentury – can be achieved through R&D activ-ities, and certain scientific or R&D achieve-ments may be developed into an innovationsubsequently. However, not all innovationshave underlying scientific work or R&D, aslinking existing pieces of industrial knowledgein a new way may also result in successful inno-vation. What is more – as shown by Schumpeter(1980, 1912) as early as at the beginning of the20th century – new production processes,organisational solutions or sales techniquesmay also be regarded as innovation6. The


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notions of science, R&D and innovation areclosely interrelated, but are not interchange-able.

Recorded and organised knowledge acceptedby the relevant trade community and alsoappraised against its own (not economic orpolitical) criteria may be considered as science.The emphasis here is on maintaining and fur-ther developing existing knowledge in line withan independent and full-fledged set of valueswhich, at least in theory, the evaluation of per-formance should not be influenced by any kindof contact with politics or the economy.

In a certain sense, R&D is to dynamise sci-ence. This is because R&D is a purposeful andregular activity aimed at creating new knowl-edge, though it is not the only way to do so. Animportant constituent in creating knowledge iseducation; however, in that field – to borrow ananalogy of the European Union's development– the emphasis is more on widening than ondeepening, i.e. enhancing individuals' personalknowledge instead of acquiring new knowledgefor the whole community.

Innovation is creation of knowledge, partlybut not fully based on R&D, which is repre-sented in new products or procedures, andenables the initiating market actor to improvetheir competitiveness. At this point, creation ofknowledge and competitiveness are truly inter-linked in a direct and salient way.

Recently, literature has devoted increasingattention to non-R&D based methods ofknowledge creation and innovation. Thisunfolding change in approaches is party fuelledby the practical experience that many types ofinnovation may represent only minimalchanges to a product, organisation or process,and still considerably improve market chances,without the need for any R&D input. At thesame time, there is also an underlying line ofthought behind this altered approach: practicaldevaluation of R&D with reference to the ideathat R&D has less economic benefit than

believed earlier, if there are considerably lessexpensive methods of arriving at innovations.Innovations as classified by economic historianJoel Mokyr into micro and macro inventionsalways required R&D in the past – certainly inline with the opportunities and customs of therelevant era – (Mokyr, 2004), and will continueto do so in the future.

The article by Lundvall and associates(2007) presents an apparently outstanding newresult in terms of the connection betweenknowledge creation and R&D, which makes adistinction between the two major models ofknowledge creation. One is the traditionalR&D based model (Science, Technology &Innovation, STI), i.e. a set of relations amongscience, technology and innovation, includingthe linear and triple helix models (for moredetails in Hungarian, see Török, 2006a). Theother one is the new DUI (Doing, Using &Interacting) model of knowledge creation,which emphasizes development of work expe-rience into innovation, using network linksamong market actors.

An important element of the latter model isthat in modern industry, many kinds of innova-tion need to be adopted and improved, insteadof being reinvented. At the same time, propa-gation of this model will necessarily devalue thetraditional techniques and procedures of pro-tecting intellectual property. Emphasis isincreasingly shifting to in-house innovationsand further development of innovations adopt-ed from others by way of experience, whichwill need no patents, for example. Anyway, aslight amount of aversion is emerging topatents in companies in certain industries,because competitors may conclude courses ofresearch and development from the patentspublished, and that is how they initiate rivaldevelopment programmes. What is more – par-ticularly in the pharmaceutical industry –patents may generate ideas to manufacturers(in the far east, for example), with weak


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enforcement facilities available in Europe,whereas competitors may even deduce themanufacturing procedures of important newproducts from the patent description, andusurp foreign knowledge to become competi-tive actors on the global market.

Science, R&D and innovation are thusclosely interrelated, but operation of thesethree areas follows partially different sets ofcriteria. The scientific set of values is relative-ly far from the strict and short-term returnrequirements of the economy, R&D moreemphatically represents the considerations ofeconomic cost/benefit, whereas innovation isexpressly an economic activity, which is pri-marily pursued today in a profit-orientedframework of enterprise. The relationshipbetween the operation of scientific, R&D andinnovation organisations and competitivenessis different presumably because considera-tions of competitiveness are represented tovarying degrees on assessing the performanceof the three areas.

With a certain amount of simplification, wemay state that it is reasonable to set criteria ofcompetitiveness and direct return

•in full for innovation, •in part for R&D,•and not at all for science – provided we

consider science7 as something only pur-sued in line with its own requirements,independent from the needs of the econo-my, and focused on knowledge creation.

According to the set of values that has beenincreasingly represented in economic policy inthe recent years in the EU and in Hungary, andalso (in certain periods, vehemently) advoca-ted by the Hungarian governments after 2004,the above statements may even sound asheresy. Although, the position about sciencedoes not imply that funding for science mayexclusively be provided by the state and exclu-sively without requirements. Today, sciencecan rarely be pursued as an unpaid hobby, but

it does not mean it is necessarily funded fromstate resources.

In wealthier countries, considerable privatecapital is used to support even the portion of sci-ence that does not guarantee economic results,in the form of foundations or through universi-ties. In those countries, the emblematic questionthat has been asked many times in Hungarybecause science has badly needed regular statesubsidy in the absence of relevant privateresources to meet long-term public interest, andin order to preserve the language and the cultur-al heritage, does not even emerge. The questionis: “How does the economy benefit from thestudy of medieval scripts?” This question hasbeen mainly asked referring to the fact that inmost years research funding was also available tothe field of liberal arts within the system ofHungarian R&D funding systems, which havebeen partly run from the contributions thatcompanies have paid on innovation since 2003.8

The obvious answer certainly is that it doesnot, but on giving a more detailed explanation,a more in-depth picture unfolds. Even abstractscience may help improve competitiveness, butoften through a number of directly non-quan-tifiable transfers, which generally cannot bepredicted.9 What is probable, though, is thatthe formation of attitudes, as well as educationnot directly developing labour market skillsmay considerably improve the quality of work-force, which also requires diverse research notnecessarily related to the economy.

Let us add a non-European example to what

has been said here: in Japan, huge amounts are

spent to develop software in the Japanese lan-

guage. Such software is certainly much more

complicated to manage compared to the

English version, and it is much more diffi-

cult/expensive to write in Japanese on comput-

ers. Would it not be a much more efficient

solution for Japanese computer users to shift

to using the English language?


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For somewhat unclear reasons though,Japanese society and economy, which are oth-erwise very much efficiency oriented, have stillnot taken this step – for some reason, theyinsist on their “low efficiency” language andculture.

SCIENCE, R&D AND EFFICIENCY

Through the Japanese example, we havereached the point of asking what limits areapplicable to the possibility and reasonablenessof extending the notion of efficiency custom-ary in the economy to fields where other meas-ures of performance – or ones interpreted on adifferent timescale only – are also used.

This is illustrated by the “paradox of the string

quartet”.10 The paradox illustrates the limits of

measuring and interpreting efficiency. The point

is as follows: a string quartet produces a CD

recording of a piece by Beethoven in year t, which

is a 40-minute performance, and it generates

USD 100 thousand to the recording company.

The same piece is recorded by the string quartet

again in year t+5. The duration of the recording

is only 37 minutes this time, but the revenue is

the same. The paradox is: does the same amount

of revenue generated from a shorter recording

mean increased efficiency 1. in an artistic, 2. in an

economic sense? The answer to the first question

is obviously no, but to the second, it is probably

'yes'. The problem is, however, that if a corre-

spondence needs to be found between the two

types of efficiency approaches, one of the

answers must be wrong. So, the essence of the

paradox is that the market in the specific case

could not appreciate artistic quality, i.e. product

differentiation did not result in a better situation

in terms of information for the demand side.

In a more general sense, the “paradox of thestring quartet” implies that efficiency-based

performance requirements have hard limitseven in the economy where output and thequantitative proportion of resources cannot beinterpreted, or only in a misleading way. Withthe paradox extended to science and R&D, itcan be established that the efficiency measurecustomary in the economy is reasonable andpermitted to be applied only to cases – fields ofscience – where the market value of output isapplicable at all. Where it is not, strict cost andcapacity limits can also be set up – for want ofsomething better –, but one cannot refer to theabsence of competitiveness, as absence of ameasure does not at all mean the same asabsence of performance.

On comparing science and R&D perform-ances on an international scale, the abovemen-tioned fields of science must be ignored; how-ever, it should be repeatedly emphasized thatthis does not mean their exclusion from fund-ing at the same time. Now, we are proceedingon to the international competitiveness exami-nation of science and R&D, but this time wewill be focussing on R&D and innovation, dueto the lack of a clean-cut competitivenessmeasure applicable to science.

In a comparison of countries, two competi-tiveness approaches are possible for R&D: thefirst one is competitiveness of each country'sR&D and system of innovations, the secondthe contribution of R&D and the system ofinnovations to the competitiveness of thewhole economy.

In order to measure the competitivenessof international R&D, it is necessary to quanti-fy the international positions achieved on the“input” and “output” sides of R&D and inno-vation (expenditures and performance). Forthis, the most frequently used charts are theproportion of the GDP applied to R&D(GERD/GDP) and human resources of R&Don the expenditures side, while performance interms of publications and patents as the outputindicator. In the international R&D rankings


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produced since the early 2000s, Hungary hasoccupied positions between 30 and 35,11

whereas the country ranked 4012 in the eco-nomic development report issued by the WorldBank in 2007. These details alone apparentlyrank Hungarian R&D competitiveness abovethe average, however, this is not the case. Theinternational ranking of economic develop-ment is not a competitiveness ranking; conse-quently, comparison of the two lists requiresgreat caution. On the other hand, there are anumber of developed countries, or ones withhigh GDP per capita indicators, where nomaterial R&D activity is pursued, or whereR&D does not contribute considerably toGDP (such are, for instance, the great oilexporting countries). Accordingly, it is point-less to link R&D and competitiveness in anyway in these countries.

Contribution of science, R&D and thesystem of innovations to macroeconomic com-petitiveness can only be represented in a con-siderably more complicated system of correla-tions. Certain simplifying assumptions areindispensable. First, let us assume thatimproved competitiveness of the nationaleconomy is seen in terms of commodityexport, or, more directly, the structure of com-modity export. This alone cannot be consid-ered a regularity at all, given that improvedcompetitiveness may also be manifest in thestructure of services export, similarly to thestructure of domestic industry supplying to theexport sector. Similarly, it must also beassumed that the achievements of science,R&D and innovations are actually representedin upgraded products, and not left on paper, orsold abroad as intellectual products.

If these assumptions are met, progress incompetitiveness can be measured by the speedof improvement in the export structuretowards products/services with higher addedvalues. A popular and relevant indicator hasbeen around in the literature, which is rather

doubtful in terms of contents: export ratio of“high-tech products”.

The details indicated in Chart 1 are spectacu-larly complemented by the indicators of a fewdeveloping countries for the year 2003: in thePhilippines, the export ratio of products deemedas high-tech13 reached 64 per cent, while theratio of electronic parts within imports 47 per cent. The corresponding two charts inSingapore were 49 and 35, in Malta 57 and 20,whereas in Malaysia 45 and 44 per cent, respec-tively, also in 2003 (Srholec, 2007). All the fourcountries are primarily known as exporters ofelectronic products, and the high import ratio ofparts suggests that a considerable portion ofmanufacturing is actually assembly.

Chart 1 and the numbers reveal that the highexport ratio of products considered as high-tech does not, in many cases, reflect the stan-dard of the domestic system of R&D and inno-vation, if the sector producing state-of-the-artelectronic or other products uses foreign tech-nology and parts, and the overwhelming major-ity of high-tech export derives from multina-tional companies assembling products in acountry, relying on foreign R&D.

The structure of the global high-tech tradedoes not truly reflect international R&D andinnovation activities because details of coun-tries are shown here, whereas the decisionsapplicable to business sites in terms of R&D,innovation and high-tech industries areincreasingly made by multinational companies.

Chart 2 reveals that the share of leadingcountries and regions in terms of R&D isdiminishing in the field of global high-techexport, while the proportion of countries spe-cialising in assembly is continuously on therise. The same process is presented from a dif-ferent angle by the fact that the United Statesof America, the absolute leader in internationalR&D and innovation rankings has been a netimporter of high-tech products for years (seeChart 3).


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Chart 2

SHARE OF KEY REGIONS IN THE GLOBAL HIGT-TECH EXPORT (1985–2005, per cent)

Forrás: NSB, 2008, Chapter 6

Chart 1

THE PROPORTION OF HIGH-TECH EXPORT AND IMPORT IN TOTAL EXPORT, 2004

Forrás: GKI-Microsoft Competitiveness Report, 2007, chart 121

GR PL RO SK SL PT EE AT CY DE FI UK FR HU JP US IE


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The link between R&D, innovation andcompetitiveness cannot be reliably representedbased on foreign trade charts, so to say. Thequestion is what other method would be suit-able to show this link, or the economic benefitof science, in a broader sense.

THE “BENEFIT” OF SCIENCE

Representation of the link between R&D,innovation and competitiveness would also benecessary because between 2005 and 2007,multiple forms of statements were voiced inpublic by leading politicians in Hungary, notalways explicitly, which questioned the benefitand point of Hungarian science and R&D andtheir various institutions from the aspect ofeconomy or competitiveness. They did statethat Hungarian science (or R&D), as well asthe Hungarian Academy of Science deservestate funding only at times and in fields whenand where they have a direct impact on com-petitiveness for improvement14.

A part of science (and R&D), however, is

incapable of immediately and directly improvingcompetitiveness, not only in Hungary but alsoin countries dominating the area of R&D. Thereason for this is a difference between the con-tent of basic and applied research. Basic researchis seen as the portion of R&D that creates newknowledge without a direct or palpable econom-ic benefit, where the end result of research isonly presumable but not clearly visible, and, forthis reason, evaluation of basic research can onlyrely on scientific considerations. For appliedresearch, however, the objective is a pre-definedresult, and, accordingly, the economic point ofapplied research is to achieve the goal.

Contrasting basic research with appliedresearch is artificial, because it emphasizes theirrivalry for resources, instead of their interde-pendence and interaction.15 In case of scarcefunding, it must certainly be accepted that sucha rivalry is present, but the comparability ofresults is very doubtful. Results of basicresearch are generally used by the domestic andforeign community of researchers, whileclients of applied research are mostly privatelyowned economic organisations – although not

Chart 3

BALANCE OF HIGH-TECH PRODUCTS TRADE IN THE UNITED STATES OF AMERICA (2000–2006, billion USD)



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excluding important government orders for thepublic good, such as urgent testing of a vaccine.

So, with certain simplification, it may bestated that basic research creates public goods,while applied research creates private goods.Consequently, a comparison of public and pri-vate goods immediately raises the issue of pric-ing for the two types of goods, when no short-term market demand is present for publicgoods, although they satisfy long-term socialneeds (such as the study of medieval scripts,cultivation of the language, or proofs ofabstract mathematical theorems).

However, the social /economic benefit ofbasic research must be determined, or at leastindicated when one intends to support itsfunding from public resources. Such benefitmay be of many kinds, but generally is notmeasurable directly the way it is for appliedresearch that is subsequently represented inproducts and services, and this is why it obvi-ously easily lends itself to political delibera-tions. The social and/or economic benefit ofbasic research – and one can state with certain-ty: the strategic increment – may consist of thefollowing factors:

• maintaining the domestic basic researchdatabase in the branches of science wherethe requirements of return are difficult tointerpret, and, consequently, funding can-not be based on revenues from the corpo-rate sector;

• supplying domestically generated R&Dresults to domestic higher education,16 and

• creating incentives to prevent migration ofresearchers. This equally includes migra-tion of researchers abroad, and fromresearch positions to companies, as wasseen in transitional European countries inthe early 90s (Biegelbauer, 2000).

An indicator corresponding to theGERD/GDP ratio17 is rarely calculated for basicresearch, although international comparisonsmade this way yield rather interesting conclu-

sions. Chart 3 indicates an expressly strong rela-tionship between the portion of the GDP spenton basic research and the development status ofR&D, and the economy. The international cut-ting edge – with outstanding indicators – con-sists of Switzerland and Israel, followed by theUnited States, France and a number ofScandinavian and South-East Asian countries. Inmoderately developed countries, however, thisratio is considerably lower. (see Chart 4)

The portion of the GDP spent on basicresearch alone does not show how importantbasic research is considered by science policyand R&D policy as opposed to appliedresearch. The proportion of basic researchwithin R&D expenditures is the right indicatorto show. It reveals that it is generally theCentral European countries (if the region istaken to include Switzerland, in line with a ten-dency suggested by old geography textbooks)that spend most on basic research within R&D,which implies a kind of central European tradi-tion in patronizing basic research.

This is shown in Chart 5, which is in seemingcontradiction with Chart 4; however, thisseeming contradiction is easily resolved.Developed countries spend relatively gener-ously on basic research (and also on R&D) incomparison to their economic performance, whilethe economies of central Europe consider basicresearch important within R&D. Tradition alonecannot be responsible for this; the relativelylow cost requirement of a significant portion ofbasic research also supports this trend (giventhat in many fields of humanities only basicresearch is available, in the first place)18, com-pared to the results that are achievable in therespective limited field of science, such as pub-lication performance.

This relatively strong commitment to basicresearch can actually be considered a Europeanpeculiarity, in comparison with the highlydeveloped overseas or English speaking coun-tries. This is certainly not meant to suggest that


567

basic research is pushed to the backgroundoutside Europe – in the United States, forexample –, as financial support for research hasquite different dimensions in developed over-seas countries, which concludes that theabsolute amounts devoted to basic research areconsiderably higher.

It is illustrated by the size of R&D budgets for

2006 at certain leading U. S. universities:19

Among American universities, it is Johns

Hopkins University that spends most on R&D:

it was USD 1500 million in 2006, which is

approximately an amount equal to the

Hungarian GERD. University of Michigan with

a USD 800 million budget for R&D, Boston-

based MIT with USD 600 million, and Harvard

University with USD 450 million correspond to

the GERD charts of European countries

between the size of Slovakia and Slovenia.

International R&D statistics present it as asolid fact that Europe lags behind the UnitedStated in terms of the R&D competition; thiswas also referenced in the documents of theLisbon Agenda (Rodrigues, 2003; Deli, 2004;Török, Borsi and Telcs, 2005; Török, 2006a;NSB, 2008b). There is an apparent understand-ing in the trade concerning the causes of thislag. Looking into it deeper, however, the expla-nation is not so simple.

EUROPE'S R&D LAG

Out of the factors that cause the EU to lagbehind the US in terms of R&D and innova-tion, two are most frequently highlighted. Oneis already known to us: on the supply side ofR&D competitiveness, the GERD/GDP ratiosmeasured are truly low in comparison with the

Chart 4

AMOUNTS SPENT ON BASIC RESEARCH FROM GDP (percentage, 2003 or 2004)


Switz

erla

nd (2

004)

Isra

el(2

003)

Fran

ce (2

004)

Unite

d St

ates

(200

4)

Denm

ark

(200

3)

Icel

and

(200

4)

Sout

h Ko

rea

(200

4)

Aust

ralia

(200

4)

Japa

n (2

004)

New

Zeal

and

(200

3)

Czec

h Re

publ

ic (2

004)

Norw

ay (2

003)

Taiw

an (2

004)

Irela

nd (2

004)

Hung

ary

(200

4)

Slov

ak R

epub

lic (2

004)

Spai

n (2

004)

Portu

gal (

2003

)

Pola

nd (2

004)

Russ

ian

Fede

ratio

n (2

004)

Slov

enia

(200

4)

Sout

h Af

rica

(200

4)

Arge

ntin

a (2

004)

Mex

ico

(200

3)

Rom

ania

(200

4)

Chin

a (2

004)


568

EU average. The actual charts fluctuatedbetween 1.8 per cent and 2.0 per cent in theperiod 2002–200720 , which is more than onepercentage point below the USA chart. Whenconsidering the EU as a single country, thechart is certainly undoubted, but when splittingthe Community into individual countries, thefield is much more differentiated. Considerablyabove the American chart – on the financingside –, Sweden and Finland are seen as the twoleading R&D powers globally, while in a num-ber of EU countries GERD/GDP indicatorsdo not exceed 0.5 percent. This, on the otherhand, is a chart characteristic of the marginalparticipants of the R&D competition (Török,2006a).

The GERD/GDP indicator (Chart 6) iswidely used in both the scientific and the busi-ness literature, to compare the R&D potentialsand performance of individual countries. In the

meantime, certain, otherwise empty thresholdvalues of the indicator gain almost mythicalsignificance (2 per cent for the EU, and 1 percent for Hungary), and many endeavour to dis-guise meeting these as strategic objectives.However, international R&D comparisonsbased on the GERD/GDP alone are pointless,as the GERD/GDP ratio could only be consid-ered as a performance indicator in case of equallevels of distribution for use and efficiency ofR&D expenses (which certainly is an illusion).It is precisely the Hungarian R&D system thatmay prove to have still better publication per-formance indicators than expected based onthe GERD/GDP ratio (Török, 2006a), which,surprisingly, suggests a relatively high averageefficiency of Hungarian R&D.

Recently, attempts have been made to provethe lag of the whole EU in terms of R&D andinnovation using the distribution of R&D per-

Chart 5

“CENTRAL EUROPEAN TRADITION”: THE PROPORTION OF BASIC RESEARCH WITHIN R&D (percentage)


Slov

ak R

epub

lic (2

004)

New

Zeal

and

(200

3)

Pola

nd (2

004)

Hung

ary

(200

4)

Switz

erla

nd (2

004)

Czec

h Re

publ

ic (2

004)

Mex

ico

(200

3)

Portu

gal (

2003

)

Arge

ntin

a (2

004)

Aust

ralia

(200

4)

Fran

ce (2

004)

Irela

nd (2

004)

Rom

ania

(200

4)

Sing

apor

e (2

004)

Spai

n (2

004)

Unite

d St

ates

(200

4)

Denm

ark

(200

3)

Sout

h Af

rica

(200

4)

Aust

ria (2

004)

Isra

el(2

003)

Icel

and

(200

4)

Norw

ay (2

003)

Sout

h Ko

rea

(200

4)

Russ

ian

Fede

ratio

n (2

004)

Japa

n (2

004)

Taiw

an (2

004)

Slov

enia

(200

4)

Chin

a (2

004)


569

formance by product, instead of theGERD/GDP indicator regarded to be low onaverage. The notion of the “European paradox”has been adopted in the collective awareness ofthe trade in this context (Papanek, 2003).

According to a widely spread interpretationof this paradox, Europe spends relatively muchon science and R&D, but it only has a limitedeffect on increasing competitiveness, becauseresults are represented more in publicationsthan in patents.

On the other hand, there are certain morerecent research results that make this conclu-sion seem simplistic. Mostly because theassumption whereby a scientific result must bepublished first (to conclude the basic researchphase, so to say), and then the applied researchphase built on basic research would be crownedwith patenting, follows the logic of the old lin-ear model of the innovation process rejected byso many. The problem is that in the globalizedinnovation systems of the 2000s, highly

exposed to strong competition, often theresimply has been no time to comply with theo-retically strict sequence of steps applicable tothe linear innovation process. Calderini andassociates (2007) believe that patenting andpublishing results are often alternatives to eachother (“activities in complementary distribu-tion”), i.e. – with certain simplification – aresult is either patented or published. In thiscase, the absence of patenting does not neces-sarily mean that the given result will notbecome an innovation.

The “European paradox” is built on theassumption that innovations are necessarilypatented. It has been known for almost twodecades now that this is not the case (Griliches,1990). Patenting new products or proceduresalso entails publishing the essence of results,which may facilitate competitors' efforts to dis-cover the new courses of research.

The strong doubt about the “European para-dox”, however, is only aimed at the paradox

Chart 6

THE GERD/GDP INDICATORS IN INDIVIDUAL COUNTRIES IN 2005

Forrás: GKI-Microsoft, 2007, Chart 106.

R&D expenses of enterprises Governmental R&D expenses


570

itself, that is, the quoted explanation to theEuropean lag in terms of R&D and innovation.The fact of lagging behind – in respect of thewhole EU – is indisputable, nevertheless. Noteven despite the fact that the publication per-formance of the EU has slightly improvedsince the early 90s, and that of the UnitedStates slightly deteriorated between 1995 and2005. In 1995, 564 645 articles were publishedon natural and technical sciences globally, ofwhich 193 337 were authored by Americansand 195 897 by nationalities of the subsequentEU-27. In 2005, these three charts were709 541, 205 320 and 234 868, respectively(NSB, 2008b, Appendix Table, 5–34),21 i.e. thenumber of American publications grew by only0.8 per cent on average, as opposed to the 2.3and 1.8 per cent for global and EU averages,respectively. Nevertheless, this only seems toindicate the relative deterioration of Americanperformance; the charts rather reflect a shift instrategies. Of all channels of knowledge cre-ation, the United States increasingly prefers“producing” innovations that can be used inthe economy, as well as higher education, andin this sense – but not simply through con-trasting patenting and publication performance– the EU can be actually shown to lag behind inthe international field.

Instead of the reviewed European paradox –which is not even expressly solid in terms ofvalidity due to flexible management of the suc-cess criterion (publication or patenting?) –,other proofs weight more when measuring theEU's lag. A particularly strong proof is theAmerican advantage in terms of good qualityhigher education, which is undoubted, as is alsosupported by a number of international univer-sity rankings.22 At least three factors can bedistinguished within this advantage, and noneof them belong to the area of R&D policywhen taken in the narrow sense.

The first factor is that not only universities butalso their support enjoy a higher social status in

the USA, compared to Europe. Concurrent pro-vision for the future and independence of uni-versities is a public cause, and multiple examplescan be quoted (for instance, the case ofPrinceton University and the associated Institutefor Advanced Study) where one of the world'sstrongest universities and research sites were cre-ated with social cooperation within a couple ofdecades. To this end, generous funding was pro-vided to reputable scientists, leaving their fullprofessional and political independence, and notrequiring them to meet short-term and detailedreporting obligations in exchange for support oftheir research. Distribution of support was muchrather determined by a value judgement of theprofessional community.

The second crucial element is that in theUnited States – and elsewhere in the Englishspeaking countries – university funding isstrongly dependent on institutional contactswith alumni. Organisations of alumni areinvolved in the governance of universities, andthey are virtually imposed a moral obligation toachieve that companies or other organisationsmanaged by alumni provide regular support ormandates to universities – as backed by cen-turies of tradition.

The third reason is that the autonomy andscope of authority of European accreditationsystems are considerably smaller than custom-ary in North-America. Higher educationaccreditation in the EU countries is generallylinked to the government in charge of educa-tion, i.e. the state even participates in runningand funding accreditation institutions termedas autonomous, in determining their composi-tion, and the rules or criteria for accreditationare also developed by the government alone.This may reduce accreditation to formal, asoften the point is not the capability of an insti-tution to provide truly high standard educationas judged by the trade, but its capability tomeet the requirements literally (and maybeonly at the moment of disclosing the data).


571

It is rather frequent in the Hungarian accredi-

tation system to have a head tutor who holds a

scientific degree (which is necessary, for exam-

ple, to head a department), and has not pro-

duced a single publication (which is only a

requirement in the form of “relevant publica-

tion activities”) in the recent years or maybe

decades (!). This generates a lot of debate: the

person formally meets the requirements, how-

ever, by higher professional standards, they

would obviously be unsuitable to perform the

respective assignment.

As opposed to this, the American system is atwo-tier one, which represents a clear-cut dis-tribution of roles among the stakeholders inthe state and in the trade. The first tier is at thestate level, which in the United States meansfederal states and accreditation consortia ofcertain member states (such as the MidwesternStates). At this level, not the professional qual-ity of education is assessed but the availabilityof technical conditions of higher education.Practically, this is where operating licences areissued to institutions of higher education. Thisdoes not yet mean accreditation, but ensuresstate recognition of the degrees issued bythem.

Accreditation itself is performed at the sec-ond level by bodies organised by higher educa-tion institutions, and in line with rules set up incooperation. This is where the professionalcontents of education is judged, the value israted, as well as determining whether it can berecommended to students. Institutions are notrequired to participate at this level of accredita-tion, but they are still strongly recommendedto do so in order to acquire or retain their pro-fessional ranks. This level of accreditation isopen on an international scale; this is why for-eign institutions may apply as well (inHungary, for example, a number of depart-ments at the Central European University holdsuch American accreditation).

The two-tier system provides a facility alsofor weaker colleges to obtain operatinglicences, but, in the formal sense, it still doesnot make them become rivals to stronger uni-versities, as the case was, for example, inHungary in the 2000s. This is how the accredi-tation system of American higher educationfacilitates coexistence of quantitative and qual-itative education besides officially recognisingoutstanding quality, and also helps to create abalance between education and R&D at univer-sities.

The three factors listed above probably havemuch to contribute not only to the outstand-ing competitiveness of American higher educa-tion but also the system of R&D and innova-tion. Concurrently, it also alludes to the factthat the competitiveness of science and R&D isfar from being a mere question of funding.

FUNDING SCIENCE AND R&D

Financial background to science and R&D isgenerally considered as the key factor to com-petitiveness. This is not disputable, whereas theexaggeration of this assumption is. As dis-cussed earlier, the scientific and R&D perform-ance or even capacity of individual countriescannot be compared using the charts ofGERD/GDP alone. Strictly speaking, it cannotbe proved, but it is held valid in internationalterms that higher R&D expenses yield morescientific and R&D results, but the results arevisible only after a lead time of years (Crespiand Geuna, 2008). Representation of resultsoften outspans the customary reporting orreturn cycles of government or corporate fund-ing, and this shift in time may also be the rea-son why return occasionally appears to be poor.

Dynamics of the GERD/GDP indicatorshow close correlation with the developmentlevel of the economy.23 Chart 7 illustrates thiscorrespondence displaying charts of 18 coun-


572

tries. Two economies deemed as successful,Finland and Japan spend considerably more onR&D than expected in proportion to theirGDP per capita indicator, while German,Hungarian and Czech charts are slightly abovethe expected values. As opposed to that,American, British and Austrian economiesdevote relatively less to R&D – at least in thiscomparison.

The GERD/GDP chart that is seeminglyhigh for Hungary and low for America here inthis comparison may provide food for thoughtconcerning whether increasing the GERD canreally mean a reserve for increasing R&D com-petitiveness and performance. The answer ispresented by another indicator or its relation toGERD/GDP.

BERD (Business Expenditure on Researchand Development) denotes R&D expendituresin the business sector, i.e. R&D expenses ofenterprises. Its ratio to the GDP is also fre-quently used in comparative R&D statistics.

This indicator shows an even closer correlationwith economic development than GERD/GDP,and, practically, also positively correlates withthe GERD/GDP ratio. In general, it can be stat-ed that higher GERD/GDP-indicators gotogether with higher BERD/GERD ratios24

(Török, 2006a). In countries that spend rela-tively the highest amount on R&D, countrieswith GERD/GDP indicators above 2 per cent,the BERD/GERD ratio is 65-80 per cent, whilein the mid-list of GERD/GDP featuring 1–2per cent it is around 50 per cent, and in thegroup of countries with a GERD/GDP below0.5 per cent, it is not more than 25 per cent(NSB 2008b, Appendix Tables 4–37,4–39). TheBERD/GERD ratio grew from 51.8 per cent to62.2 per cent on average in the OECD between1981 and 2004 (NSB 2008b, Appendix Table4–39).

What all this means is that the proportion ofR&D financed by enterprises at the level of thenational economy rises in both time and space

Chart 7

CORRELATION BETWEEN ECONOMIC DEVELOPMENT (GDP PER CAPITA) AND PROPORTIONATE R&D EXPENDITURES, BASED ON 2005 CHARTS

Forrás: the author’s calculations based on NSB charts

Spend less than suggested by their development statuses

GDP

per c

apita

(EU-

27=1

00)

GERD/GDP (%)

Spend more than their development suggests

n Hungary, the two charts roughly correspond

R2=0,6833


573

with economic development. In more devel-oped countries, the engine of development istechnological upgrading, instead of usingalways additional resources of invariable quali-ty. In this way, it is reasonable to expect thestate to increase the total expenditures onR&D (GERD/GDP) only if it has an actuallyperceivable impact of developing the economy,because in that case the GERD/GDP ratio isexpected to continue rising along withincreased corporate spending on R&D.

In this case, political economic debates rem-iniscent of the “chicken or egg” dilemma andstandpoints full of politically motivated simpli-fications are common. According to a typicalopinion, the key task of the government'sR&D policy is to encourage enterprises to raisetheir R&D expenses, which is primarily con-ceivable by fiscal means. A partial counter-example to this concept is the Hungarian cor-porate contribution to innovation introducedin 2004, which the majority of enterprises arerequired to pay unless they use it for research.A number of companies give mandates of R&Dfor contents indifferent to them to “friendly”R&D organisations, as a form of self-help. Thisis a way to drive up the Hungarian BERD indi-cator at least nominally. The counter-example,however, is only partially valid because theamount of contributions paid by companies forinnovation should have been complemented bythe government to double in amount everyyear, which the government never did.Consequently, the expected impact on stimu-lating expenses was only partial.

The other major concept is that the state issupposed to re-establish Hungarian R&Dusing funds from the central budget, and onceits chronic financial undernutrition has beeneliminated, it will become more competitive,and may better facilitate competitiveness ofenterprises. The logical error here is that theHungarian system of R&D needs interventionnot only financially but also regarding its insti-

tution and operation. I do not wish to recallhere the frequent attacks against the HungarianAcademy of Sciences and basic research –including various articles by Béla Darvas,György C. Kálmán, Csaba Szabó and IstvánPolónyi between 2006 and 2008 –; nevertheless,a purposeful and sensible renewal of the HAS(not necessarily a reform, as suggested by theplatitudinous expression) is surely in the bestinterest of the scientific community. The effi-ciency of the Hungarian system of science andR&D would be very difficult to improve untilclear criteria for efficiency are set up for scienceand R&D, the absence of which is discussed inthis paper.

With sufficient political courage and deter-mination, however, a number of operating dis-orders could be eliminated. Only a few exam-ples:

• on reforming the Hungarian system of sci-entific ratings in the early nineties, respon-sibility for rating was uncritically assignedto universities; however, excessive respectfor university autonomy considerably pre-vents truly thorough and regular monitor-ing of the contents and standards of PhDcourses.25 The Hungarian system of scien-tific ratings would require an in-depthreconsideration, resulting in stricter meas-ures for PhD degrees at most universities,and national standardisation of certaincomponents of such measures;

• performance evaluation of Hungarianresearch sites is primarily at an institution-al level, i.e. in the shadow of a few well-performing associates, a number of othersmay get by without any acceptable prod-ucts. Truly individual performance apprais-al would be necessary;

• on appraising researcher performance,spectacular new “panaceas” that often turnout to lack contents should be eliminated,such as involving foreigners in evaluatingHungarian research institutions. In gener-


574

al, it is an unnecessary burden for foreignresearchers to perform external appraisal(or other) tasks in Hungary on a courtesybasis, and if the appraisal is made on a rec-iprocity basis (in as many as three or moresteps)26, the result can be predicted withgood probability. This method (or require-ment) does not promise success because itis built on the illusion that the cohesion ofdomestic researcher networks and, conse-quently, its effect on distorting evaluation,is necessarily much stronger than that ofinternational ones with Hungarian partici-pation;

• not contrary to the above remark, an effortshould be made to break the often gravelyadverse circles of inside references,appraisals and promotion in Hungary –even at the cost of breaching vested inter-ests.27

Solution to a portion of all institutional andoperating problems, however, cannot make upfor the pressure to select a strategic path.Beyond all this, the core question (“chicken oregg?”) of the Hungarian government's R&Dstrategy is ultimately whether it is a higherGERD/GDP that accelerates economic devel-opment, or higher economic development thatfacilitates more R&D and scientific expenses.It would be reasonable to take a balancedstance on this issue, because the correspon-dence between R&D expenses and economicdevelopment, or competitiveness is necessarilybidirectional.

In the longer term – but due to the nature ofscientific research, only partly in line with thestrict and time-restricted requirements ofreturn customary in business – it is certainlytrue that a higher level of scientific and R&Dexpenses improves the competitiveness of thewhole economy. Consequently, funding forR&D must also be increased in Hungary, andthe role of the state in that cannot be neglect-ed.28 Rising R&D spending at companies can-

not be achieved simply by the government tak-ing a toll on the business world also in this area,quoting the shortage of its resources. Suchcompany resources may indeed be received ona charity basis by research foundations, forexample. This, however, is a much lower orderof magnitude compared to a situation wherethe actors of the Hungarian business sectorspend on R&D truly keeping their own eco-nomic interests in mind, similarly to companiesin more developed countries.

More developed countries are able to spendmore on science and R&D also in the shortterm, precisely due to stronger average orienta-tion towards R&D, but they have laid the foun-dations of this higher level of development notonly through expanding R&D resources inadvance, but also through other investmentsinto improving competitiveness with no short-term return. In particular, such areas of invest-ment are education, healthcare and infrastruc-ture, for example. In the first decade of the2000s, it is a widely known and undoubted factthat countries that developed in line with a per-manent “consensus on convergence”29

(Finland, South Korea, Israel, Singapore) spentabove the international average on education,healthcare and infrastructure, in addition toscience and R&D. With an expression bor-rowed from Béla Kádár, the elimination of per-manent economic and social deficits is neces-sary also in the abovementioned areas to initi-ate fast convergence (Kádár, 2008), and partic-ularly in order to improve the quality of humanresources.

SCIENCE AND COMPETITIVENESS

The international positions of Europe andHungary have indeed deteriorated in the scien-tific and R&D competition within the past oneor two decades, but neither of them are inferi-or to the respective positions of the EU and

1 A non-exhaustive list: Nyíri (1996), Török (1996),Török (1997), OMFB (1999), Biegelbauer (2000),Török (2000), Braun et al (2002), Nikodémus(2003), Siegler (2003), Borsi – Telcs (2004), Hohl –Holczer – Pál (2004), Báger – Goldperger – Varga(2005), Török – Borsi – Telcs (2005), Török (2006a)

2 Nevertheless, in other publications he discusses thecompetitiveness problems of the American economy(Krugman, 1996).

3 Potential interpretations are, for example, related tothe field of “game theory” (one can only improveone's position to the debit of others), the “neoclassi-

cal” interpretation (assuming pure and perfect com-petition), “classic social sciences” (one can only seekto improve one's position until it breaches others'rights), or the “shorthand” interpretation as suggest-ed by Bork (competition is an ideal state in the mar-ket, when consumers' welfare cannot be furtherimproved through state intervention). It is easy tosee the material differences among these.

4 A conceivable option for a solution is to try and linkthe notion of competitiveness to the theory of com-parative advantages, or, more broadly speaking, thetheory of foreign trade advantages. For such anattempt, see Török (2008a).


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Hungary in the global economic competition.A certain decrease of R&D competitiveness ofthe EU and within it Hungary is currently thecase, increasing the that – maybe in one or twodecades – the centres of high-quality knowl-edge production will gradually disappear fromEurope. The process is currently underway,which is conclusively proved by internationalhigher education rankings, despite theirmethodological mistakes.

The science and R&D policies of the EU,including Hungary should find a strategicresponse to make up for this loss of R&D com-petitiveness. In a competitiveness approach,however, it is to be seen that such a strategicresponse cannot be limited to the nationalinnovation system in a narrow sense. In orderto improve the competitive performance30 ofscience and R&D, the best possible set of toolsshould be determined within economic andsocial policy.

In addition to support for actors and areasthat promise direct improvement in competi-tiveness, an expedient strategic response wouldalso represent improvement to institutionaland financial conditions. In this context, itwould be reasonable to quit the traditionalnotion of “technology” as restricted to solu-tions or procedures of natural sciences and

technology, and acknowledge the key impor-tance of developing “social technologies”(Nelson, 2008). This consists of R&D, educa-tion and healthcare, but development of “socialtechnologies” also includes upgrading publicadministration, and even the development oftransport systems and housing conditions.

Observing considerations of competitive-ness in science and R&D is justified where anactual objective measure of competitiveness isavailable. Nevertheless, we must be cautiousnot to accept these competitiveness compar-isons as serious competitiveness rankings31

immediately once they exist. If we actually pos-sess methodologically acceptable competitive-ness surveys on science and R&D, a kind ofcompetitiveness measure may really be set upfor the R&D policy, certainly considering long-term effects and requirements of efficiency.

Selection in the field of R&D policy shouldindeed “suppress” areas of weak competitive-ness, and not the ones where competitiveness isnot even measurable, strictly speaking. The lat-ter includes basic research, in the first place. Itshould be considered as a positive externalityfrom the perspective of the economy and thewhole R&D, whose funding constitutes a pub-lic cause, and whose control should not havefinancial criteria in the foreground.

NOTES


576

5 For simplicity's sake – due to the nature of our sub-ject – only cases of analysing international competi-tiveness will be addressed in the continuation.

6 The reason why it is important to examine the corre-lations between R&D and competitiveness is thatinnovation capacities of social sciences may beproved this way.

7 In terms of contents, basic research is referencedhere, but this term will not be used until fully clari-fied.

8 The indirect benefit of research into social sciences –economics, law, sociology, regional science and oth-ers – is generally less argued even among the follow-ers of science funding on a profit-oriented basis.

9 An example that is considered classic today: researchinto number theory was not regarded serious andworthy of state support until its economic benefitwas revealed in terms of developing methods ofencoding and cryptography (Török, 2006a).

10 The author has a number of encounters with it onconferences, however, has not managed to find areference to it in the literature.

11 For details on the methodology of internationalR&D rankings and the possible results of ranking,see Deli (2004), Török, Borsi and Telcs (2005);Török (2006a).

12 Source: www.worldbank.org.

13 This rating is generally based on the OECD's sys-tem, which, in turn, classifies broader productgroups in so-called high, medium or low level high-tech products. This system of classifications is con-sidered to be rather lax in terms of defining high-tech.

14 These statements have been mostly made by variousexecutives at the Ministry of Economy. See, forexample, Kóka: The work of Nobel laureates ismade more difficult by the fact that most of themare dead”. Index, 2 May 2005 ; Schermeier, Quirin:Hungary's science academy slammed as 'obsolete'.Nature, 29 June 2006.

15 Contrast probably dates back to the older, “linear”model of innovation systems, where innovation is athree-stage linear process (basic research › appliedresearch › experimental development). More up-to-date models, particularly the “triple helix” model

emphasize the shared features and constant inter-weaving of the three stages.

16 Here a peculiar version of the free-rider problem.Where domestic basic research withers, higher edu-cation is increasingly forced to work from curriculaadopted from abroad, because they have no bespokescientific results to use. This ultimately leads to alower quality of Ph. D., subsequently of M. A. levelhigher education, followed by an increased migra-tion of students abroad.

17 GERD (Gross Expenditure on Research andDevelopment) compares all R&D expenses toGDP.

18 An illustrative and relevant expression in AmericanEnglish is blackboard sciences, referring to researchthat only requires paper, books and pencils – butthey still do not denote basic research only, becausethis illustrative definition is assigned on the basis oftools and not objectives.

19 Source: NSB, 2008b, Appendix, Table 5-11

20 Source: www.cordis.lu.

21 In this period, the annual number of articles regis-tered by the NSB rose from 1764 to 2614 (NSB,2008b, Appendix Table 5-34).

22 Full acceptance of international university rankingsis hindered by a number of methodological prob-lems. Within the narrow group of leaders, however,the dominance of US universities is undoubted(Török, 2006b).

23 For a detailed explanation, see (Török, Borsi andTelcs, 2005; Török, 2006a).

24 The share of the business sector in the total R&Dexpenditures of the country.

25 This remark also applies to the Hungarian system ofaccreditation in place in 2008 and for one and a halfdecades prior to that, but there is no space here toexplain in more detail. Nevertheless, the customthat lecturers are allowed to obtain PhD degrees attheir own universities and continue working thereneeds urgent revision. This practice is termed“endogamy” in jargon. In North-America, the cus-tom is not to obtain a PhD degree where one teach-es or will teach after obtaining the degree, while“endogamy” is more typical of continental Europe.The ratio of university lecturers with internal PhD

AGHION, PH. – DEWATRIPONT, M. – HOXBY, C. –MAS-COLELL, A. – SAPIR, A (2007): Why reformEurope's universities? Bruegel Policy Brief, Issue 4.September

AROCENA, R. – SUTZ, J. (2001): Changing knowl-edge production and Latin American universities,Research Policy, 30., pp. 1221–1234

BÁGER, G. – GOLDPERGER, I. – VARGA, GY. (2005):From research to innovation – the situation of R&Dactivity, and certain correlations with efficiency andfunding in Hungary, Research and DevelopmentInstitute of the State Audit Office, MódszertaniFüzetek [Methodological Brochures], Budapest,October

BIEGELBAUER, P. S. (2000): 130 Years of catchingup with the West. A Comparative Perspective onHungarian Industry, Science and Technology Policy-making Nince Industrialization. ContemporaryTrends in European Social Sciences, Ashgate,Aldershot, p. 250.

BORK, R. H. (1993): The Antitrust Paradox. A Policy at War with Itself, The Free Press, New York,479, (first edition 1978)

BORSI, B. – TELCS, A. (2004): International com-parison of R&D activities based on country statis-tics, Közgazdasági Szemle [Economic Review],Volume LI, February, pp. 101–126

BRAUN, T. – GLÄNZEL, W. – NÉMETHNÉ, KOVÁCS É.– PERESZTEGINÉ, SZABAD, ZS. (2002): The position ofHungary in the world of natural science basic research– Scientometrics landscape at the end of the secondmillennium, Magyar Tudomány [Hungarian Science],No. 7. pp. 935–945

CALDERINI, M. – FRANZONI, CH. – VEZZULLI. A.(2007): If star scientists do not patent: The effect ofproductivity, basicness, and impact on the decisionto patent in the academic world, Research Policy,Volume 36, Issue 3, April, pp. 303–319

CRESPI, G., A. – GEUNA, A. (2008): An empiricalstudy of scientific production: A cross country analy-


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degrees is 69 per cent in Spain, 63 in Belgium, 58 inSweden, 49 in Ireland, 40 in Germany and only 8 percent in the United Kingdom (Aghion et al., 2007,table 3).

26 I.e.: A appraises B, B appraises C, and C gives anopinion on A.

27 Only one example of this from the author's ownexperience: Department IX of the HungarianAcademy of Sciences (the Department ofEconomics and Legal Studies) has operated a com-mittee since 1998 for preliminary assessment ofapplications for the title D. Sc (Doctor of Sciences,a Hungarian academic equivalent of tenured profes-sorhip)., with the participation of almost 25 repre-sentatives holding academic doctorate degrees ineconomics. However, D.Sc. theses can also be sub-mitted to Department IV of the HAS (theDepartment of Agricultural Studies), to theAgricultural Economics Committee, and these the-ses are ultimately judged by way of voting by theagricultural researcher members of Department IV.Until 2008, all efforts made by Department IXfailed to achieve that the two departments establishshared standards to D. Sc. theses in economics.Similarly, they failed to put through that the major-

ity of academic representatives of economics inDepartment IX can vote on D. Sc. theses in agricul-tural economics.

28 By analysing Spanish data, and also processingsources on other EU member states, Gonzálezand Pazó (2008) show that the displacementeffect is generally not valid for state financingof R&D. Growing state support of R&D doesnot result in diminishing corporate R&Dexpenses.

29 This term is not used in the literature in a generallyaccepted sense. In our understanding, it meanscooperation underlying the economic and socialconvergence among political forces, involving broadsocial strata. This agreement does not exclude dailypolitical struggles, but assumes continuous andstrong cooperation among actors in politics interms of strategic issues of convergence.

30 Referring to the previously mentioned “string quar-tet paradox”, the term “effectiveness” is on purposeavoided here.

31 For bad examples, see Hungarian higher educationrankings (in more detail: Török, 2008b).

LITERATURE


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sis, 1981-2002, Research Policy, Volume 37, Issue 4,May, pp. 565–579

DELI, ZS. (2004): International rankings of R&Dactivities, Fejlesztés és Finanszírozás [Development andFinancing], No. 2, pp. 41–50

GONZÁLEZ, X. – PAZÓ, C. (2008): Do public subsi-dies stimulate private R&D spending? Research Policy,Volume 38., Issue 3, April, pp. 371–389

GRILICHES, Z. (1990): Patent Statistics as EconomicIndicators: A Survey, Journal of Economic Literature,Volume, XXVIII (December): pp. 1661–1707

HOHL, F. – HOLCZER, M. – PÁL, A. (2004): Acomparative examination of the situations in theEuropean research region and Hungary, EU-tanul-mányok [EU Studies], II. Nemzeti Fejlesztési Hivatal[2nd National Development Agency], Budapest, pp.981–1037

KÁDÁR, B. (2008): Our deficits, Pénzügyi Szemle[Financial Review] No. 2, pp. 171–182

KRUGMAN, P. – OBSTFELD, M. (2003): InternationalEconomics. Theory and Economic policy, Panem,Budapest

KRUGMAN, P. (1994): Competitiveness: a dangerousobsession. Foreign Affairs, No. 2, pp. 28–44

Krugman, P. (1996): The Age of DiminishedExpectations, The MIT Press, 1994 (Revised andUpdated, 1996). p. 239

LUNDVALL, B.-A. – BERG JENSEN, M. – JOHNSON, B.– LORENZ, E. (2007): Forms of knowledge and modesof innovation, Research Policy, Volume 36, Issue 5,June, pp. 680–693

MOKYR, J. (2004, originally 1990): The Lever ofRiches. Technological Creativity and EconomicProgress, Nemzeti Tankönyvkiadó [National TextbookPublisher], Budapest, p. 487

NELSON, R. R. (2008): What enables rapid eco-nomic progress? What are the needed institutions?Research Policy, Volume 37, Issue 1, February, pp.1–11

NIKODÉMUS, A. (2003): Perspectives of domesticinnovation on the eve of our accession to the EU,Külgazdaság [Foreign Economy], Volume XLVII., No.12, pp. 37–52

NSB (2008a): Science and Engineering Indicators.Volume 1., National Science Board, Washington, D. C.

NSB (2008b): Science and Engineering Indicators.Volume 2., Statistical Appendix, National ScienceBoard, Washington, D. C.

NYÍRI, L. (1996): Lagging behind or keeping upwith knowledge intensive development, DomesticR&D as reflected in OECD processes, KözgazdaságiSzemle [Economic Review], Volume 43., No. 6

OMFB (1999): Major correlations in the Hungariansystem of innovations, Országos Mûszaki FejlesztésiBizottság [National Technical Development Committee],Budapest, p. 149

PAPANEK, G. (2003): The “European paradox” inthe Hungarian R&D sector, Fejlesztés és Finanszírozás[Development and Financing], No. 4, pp. 40–47.

RODRIGUES, M. J. (2003): European Policies for aKnowledge Economy, Edward Elgar, Cheltenham, UK– Northampton, MA, USA, p. 169.

SCHUMPETER, J. A. (1980, originally 1912): Theoryof Economic Development, KJK, Budapest, p. 320

SIEGLER, A. (2003): The European research regionand Hungary, Európai Tükör [European Mirror]. No.2, pp. 33–53

SRHOLEC, M. (2007): High-Tech Exports fromDeveloping Countries: A Symptom of TechnologySpurts or Statistical Illusion? Review of WorldEconomics – Weltwirtschaftliches Archiv, Volume 143,Number 2., pp. 227–255

TÖRÖK, Á. (1996): Diffusion system of R&D inHungary, Külgazdaság [Foreign Economy] 40, No. 5,pp. 63-72

TÖRÖK, Á. (1997): The first comprehensive projectevaluation attempt in Hungary, Közgazdasági Szemle[Economic Review, No. 1, pp. 69–82

TÖRÖK, Á. (2000): Is position 20 held by Hungarianscience in the (imaginary) global ranking realistic?Magyar Tudomány [Hungarian Science], No. 11, pp.1307–1328

TÖRÖK, Á. (with Balázs Borsi and András Telcs,2005): Competitiveness in R&D. Comparisons andPerformance, Edward Elgar, Cheltenham, UK –Northampton, MA, USA, p. 251


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TÖRÖK, Á. (2006a): A strategic sector with no strat-egy? Performance and competitiveness of Hungarianresearch and development in international compari-son, Savaria University Press, p. 252

TÖRÖK, Á. (2006b): Competitiveness of Europeanhigher education and Lisbon objectives. How credible areinternational university rankings? Közgazdasági Szemle[Economic Review], Volume LIII, April. pp. 310–329

TÖRÖK, Á. (2008a): Export competitiveness and thecatch-up process in Hungary (1996–2001): a compar-ative analysis with some reflections on trade theory,Competitiveness Review, An International BusinessJournal, Volume 18, No. 1–2, pp. 131–153

TÖRÖK, Á. (2008b): Performance measurement andranking in Hungarian higher education, Educatio, (inpreparation).

PUBLIC FINANCES – Monetary and fiscal system

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E

Gusztáv Báger – Gyula Pulay

Major conclusions from themacroeconomic risk analysisof the 2009 budget bill

Every year, the State Audit Office (SAO) gives anopinion on the budget bill, examining if the plan-ning methods applied and the amendments pro-posed by the regulators back up the implementa-tion of the main appropriations of the budget bill.

THE ANTECEDENTS OF THE RISK ANALYSIS STUDY OF THE YEAR 2009

When working out its opinion on the 2008budget, the State Audit Office Research andDevelopment Institute (SAO-RDI) made anevaluative study on the macroeconomic founda-tions of the bill in October 2007, so as to pointout to the National Assembly the risks involvedin the bill. The study put at the disposal of theNational Assembly in October 2007 and utilisedin the budget debate established the following risksof considerable significance:

• in the year 2008, the economic growth ratewill fall short of government predictions by afew tenths per cent and, from 2009 on, GDPgrowth will accelerate less dynamically;

• in 2008, inflation will significantly exceedthe level predicted by the government;

• the growth of gross average earnings in thecompetition sphere will significantlyexceed the level taken as a basis when mak-ing the predictions.

Considering these three factors, the study bySAO-RDI also formulated numerical values,which thus can be compared to those in theautumn 2007 and autumn 2008 predictions ofthe Ministry of Finance (MF). These data aresummarised in Table 1. As the table reveals, therisks disclosed by the SAO-RDI study were soreal that they did in fact come true in 2008. Thedirection of divergence from government pre-dictions was established correctly in all thethree cases.

Despite the fact that the risks indicated in thestudy actually became reality, it is important tounderline that what SAO-RDI prepares is notactual macroeconomic predictions but a budgetrisk analysis. This takes government predictionsas a basis and examines, compared to the for-mer, changes of what size, in which directionand at what likelihood are probable to takeplace. The aim of the analysis is to reveal thedangers (chances) that are of high likelihoodand which may cause considerable divergencefrom the government predictions, i.e. whichinvolve risks in attaining some important bud-get objective. Accordingly, risks analyses, too,include predictions. These are, however, notindividual predictions on respective macroeco-nomic parameters (e.g. inflation) but the valuesof estimated divergence from government pre-dictions. The worked out methodology of


581

macroeconomic budget analysis has been pub-lished in various professional journals – includ-ing the Public Finance Quarterly – in 2008.

The experience of the debate on the firstmacro study shows that macroeconomic riskanalysis may be an important method of prepar-ing an opinion on the budget bill. It has alsobecome clear, at the same time, that in thisphase of budgeting, there is insufficient timealready to look for less risky alternatives.Considering this, it was at the expected time ofthe publication of the government's budgetprinciples, in May 2008, that the president ofSAO presented the new evaluative study ofSAO-RDI on a few correlations of the macro-economic scope of budget planning for 2009 tothe National Assembly.

STUDY ON THE MACROECONOMICRISKS OF THE 2009 BUDGET

In October 2008, SAO-RDI made its thirdmacroeconomic study, drawing the attention ofthe National Assembly to the macroeconomicrisks related to the 2009 budget. The evaluationof risks took place under extraordinary circum-stances. The government submitted the 2009budget bill to the National Assembly by thedeadline, at the end of September. In its studyentitled The analysis of the macroeconomicrisks of the 2009 budget, SAO-RDI preparedan evaluation of the government's macroeco-nomic predictions serving as the basis for thebill, revealing extremely serious risks. Thestudy was sent by the president of SAO to the

National Assembly, the minister of finance aswell as the government organs concerned onOctober 15. Prompted by the internationalfinancial crisis rapidly deepening from the endof September, the government withdrew thebill and, on October 18, submitted a revised(second) bill. The greatest changes in the latterwere the reduction of the earlier predicted 3.0per cent GDP growth rate to 1.2 per cent and,in relation to this, the reduction of the growthrates of both export and import. Within a fewdays it became clear that even these macroeco-nomic predictions were too optimistic.Realising this, the government was forced towork out new macroeconomic predictions,which expect 1 per cent fall in GDP already.The latter predictions were subjected to a riskanalysis by SAO-RDI once again, which analy-sis – attached to the opinion of SAO – was sentby the president of SAO to the committee ofthe National Assembly in charge on November2. Considering this situation, in addition topresenting the main messages of the originalSAO-RDI study, the main conclusions of thesubsequent analysis are also to be outlined in thisarticle.

The October study of SAO-RDI examined,clustered in four topics:

• the risks in the budget processes (in thechange in the structure of expenditure, infactors affecting the balance) as reflectedin the Convergence Programme (CP);

• demand risks, including world economicprocesses, the role of state demand, theimpact of EU subsidies, developments inhousehold income and consumption;

Table 1

THE RISKS PREDICTED BY SAO-RDI AND THEIR LIKELY REALISATION IN 2008

Description MF, October 2007 SAO-RDI, October 2007 MF, September 2008GDP volume index 2.8 2.4 2.4

Inflation rate 4.5 5.5 6.5

Gross average earnings 5.4 6.5 – 7.0 8.6


582

• risks originating from the improper opera-tion of certain fields of the economy,including factors affecting competitive-ness, employment processes, the system oftaxation, the implementation of healthpolicies, the operation of the local govern-ment system;

• some important correlations of sustainingbalance targets and the scope of economicgrowth.

In this article, we shall first present themost important results of the analysis of thebudget processes of 2006–2008, to be fol-lowed by a short summary of the risks relatedto the development of demand and originat-ing in the improper operation of certain fieldsof the economy, and finally by a detaileddescription of the conclusions to be madefrom the analyses and model calculationsrelated to balance targets and economicgrowth correlations.

THE (BUDGETARY) IMPACTS OF THECONVERGENCE PROGRAMME

Macroeconomic impacts

The macroeconomic indicators included in theCP passed in December 2006 and amended inDecember 2007 and the most importantmacroeconomic indicators currently known aresummarised in Table 2.

The table clearly reveals the growth indica-tors less favourable compared to the originalplans of the year 2007: the direct and indirect –implemented through inflation – impacts offiscal correction are to be felt not only in com-munal but also in household consumption. Thelittle rise in purchased consumption was finallymade possible by an increase in householdloans. It can be established furthermore thatthe scarce economic growth of the year 2007was due to the dynamic growth of foreign trade

Table 2

THE DEVELOPMENT OF THE MAJOR MACROECONOMIC INDICATORS

Description plan, plan, fact 2007 2008 2007 2008 MF-predictions, October 2008

Macroeconomic indicators in percentage of the previous year

GDP-volume change 2.2 2.8 1.1 1.8

GDP domestic use 0.5 0.9 –1.0 2.1

Household consumption –0.8 0.5 –1.8 0.9

including: household consumption expenditure –0.3 1.2 0.7 1.1

Communal consumption –1.6 –3.5 –2.2 –2.0

Gross fixed asset accumulation 2.4 4.2 1.5 1.0

Export volume change 10.6 12.9 15.9 7.6

Import volume change 8.2 11.1 13.1 8.1Living standard indicators

Real salary per earner –4.2 0.4 –4.8 –

Number of employees –0.5 0.2 –1.1 – 1.0

Inflation (annual average) 6.2 4.8 8.0 6.4Financial balance indicators

General government balance (cash flow) –6.9 –4.5 –5.4 –3.4*

Government sector balance (EASA) –6.8 –4.0 –5.0 –3.4

Public debt (ESA) 71.3 65.8 65.8 65.6

* not including local governments ESA


583

turnover and especially the improvement of netexports within the latter, which, again, was fos-tered by the decrease in import demand as aconsequence of the fall in domestic demand.

Considering world economic processes, inSeptember 2008 the Ministry of Financeamended the spring predictions for the year2008 and, instead of the earlier planned growthof 2.8 per cent, it held only 2.4 per cent growthfor possible, primarily due to the significantlydecreasing foreign trade dynamics.1 Accordingto the amended predictions, both inflation andgross salary rise would significantly exceed theplanned values, rising by 6.5 per cent and 8.6per cent respectively on an annual average.

Summarising the macroeconomic impacts ofthe CP measures experienced so far, it can beestablished that they have slowed down eco-nomic growth and increased the inflation pres-sure to a greater extent than expected, and thenumber of the employed has fallen as well.

Budgetary impacts

In the financial-budgetary balance, there hasbeen a spectacular improvement. It can beestablished from the factual data of the finalaccounts that, in 2007, the higher than plannedimprovement in the balance (compared to2006, there was a fall of 3.8 percentage points inthe cash flow deficit and a fall of 4.3 percentagepoints in the ESA-balance) was, in addition tothe omission of one-time items, primarily fos-tered by the higher than planned tax revenuesattained as a consequence of the tax increasesand the measures implemented for whiteningthe economy. Compared to the factual numberof 2006, tax and contribution revenues rose byGDP 2.5 per cent on the whole while, in thebalance of expenditure, they fell by 2.0 per-centage points.

In 2008, the budget balance, considering thedata so far – the data of the first half of the year

or of January to July – has been morefavourable than planned, in which the lowerbase of the year 2007 has a significant role.After the favourable, 5.4 per cent base in theyear 2007, an improvement of “only” 1 per-centage point is necessary in order to meet thecommitment of 4.4 per cent cash flow deficit.2

According to the analyses and government pre-dictions made so far, the most important taxand contribution revenues are to be met; whatis more, they, expressed in GDP percentage, areto be some 0.5 percentage points higher thanplanned. According to the Ministry of Finance,the majority of expenditure predictions weremet time-proportionately in the first half of theyear or, what is more, even underperformingthe predicted figures, while in the case of someappropriations, extra expenditure can beexpected.

Analysing the correlations between the cashflow data of the budget and the tax burden, wehave estimated the main figures of the 2008budget (revenues and expenditure) and thelikely divergence from the plans in the devel-opment of the structure of expenditure.According to the September estimation by theMinistry of Finance, income centralisation in2008 – including the surplus of other revenues– may be by 0.5–0.6 percentage points higherthan the factual level in 2007. The changes inthe corner figures of the CP are summarised inTable 3.

As can be seen, the fiscal correction in 2007was implemented alongside a centralisation 2.2percentage points higher compared to 2006 and0.7 percentage points higher than the targetvalue set for 2007 in the CP, which will affectthis year's level as well. The development of theindicator is partly due to the lower nominalGDP prompted by the lower than expectedgrowth rate and the stronger than estimatedeffect of economic whitening. The ambitiousincome centralisation target set in the CP for2009 originally, which is some 2 percentage


584

points lower than the current level, could onlybe implemented by significant tax reduction, theconditions for which are not available, however.

The answer to the question to what extentvarious fields of expenditure (operation of thestate, education or health care, etc.) have beenaffected by the balance improvement measuresof 2007 or, to be more precise, relative savingsin which state function categories have con-tributed to the improvement of the balance towhat extent, can be found by the comparisonof functionally distributed data. The relevantmain figures are summarised in Table 4.

The first two columns of the table demon-strate the differences in the structure of statefunctions in Hungary and in the EU-15.Considering this, we have tried to “criticise”the original target figures of the CP, too, exam-ining to what extent the planned structure ofstate expenditures was likely to serve real con-vergence, i.e. to what extent it would approachthe structure in the EU-15. The table revealsthat, while the size of redistribution inHungary is just a little above the average of theEU-15, there are quite significant differences inthe structure of expenditures.

Table 3

THE IMPLEMENTATION OF THE CP BUDGETARY CORNER FIGURES* SO FAR

In GDP percentage fact, CP, fact, CP, expectation, CP, 2006 2007 2007 2008 2008** 2009

Revenues of the government sector 42.6 44.1 44.8 44.2 45.4 43.3

including: tax burden 37.0 39.1 39.5 39.0 39.6 38.3

Government sector expenditure 51.9 50.3 49.8 48.2 49.2 46.5

Government sector balance –9.3 –6.2 –5.0 –4.0 –3.8 –3.2

* Under ESA, 95 methodology

** September estimations by the MF

Table 4

THE FUNCTIONAL STRUCTURE OF STATE EXPENDITURE IN HUNGARY AND THE EU AVERAGE

Key functions EU-15 Hungary Hungary2005 2005 2005 2006 2007 2008 expectation*

in GDP percentage

Operation of the state 7.1 8.8 8.6 8.4 8.2 7.5

Welfare functions 32.8 30.7 31.7 32.1 30.9 30.6

including: Education 5.2 5.8 6.4 6.2 6.1 5.6

Health care 6.6 5.5 5.3 5.2 4.6 4.4

Social protection 18.8 16.9 16.2 17.0 16.8 17.2

Economic functions 4.5 6.2 6.9 8.4 7.7 7.2

Expenditure on interests 2.8 4.1 4.2 4.1 4.0 4.2Total 47.2 49.9 51.6 53.3 51.1 50.2

**Own estimations using the interim data and predictions of the MF

Note: The first two columns present data according to ESA95 methodology; the source is the EUROSTAT data base. The other four columns aredata from Hungary; the source is the cash flow-oriented final accounts.


585

The average of the EU-15 is exceeded by1.7 percentage points regarding the expendi-ture on the operation of the state, by almost 2 percentage points in economic functions, by0.5 percentage points in GDP proportionateexpenditure on education and by 1.3 percent-age points in the expenditure on interests,while the expenditure on welfare function out-side education is 2.5 percentage points loweron the whole.

Within the latter, the rate of state expendi-ture on health care was over 1 percentage pointlower and that on social protection (socialsecurity and social expenditure, the greater halfof which is pensions) was almost 2 percentagepoints lower than the average of more devel-oped countries already in the year 2005.

Let us now examine how the structurechanged in the year of state overexpenditure in2006 and the two years of fiscal restrictions fol-lowing!

There has been only a slow decrease in thesize of the function of state operation, while,after the rise in 2006, the GDP-proportionatevalue of welfare functions has been graduallyfalling, i.e. getting further from the average ofthe EU-15.

Within welfare expenditure, the share ofstate participation in health care has drasticallyfallen; by the end of the year 2008, the lagbehind the average of the EU-15 is to be 2 per-centage points already.

In 2005, the rate of expenditure on educa-tion was still higher in Hungary than the aver-age of the EU-15, but it has gradually decreasedsince then and, if appropriations are met in2008, it will drop to under the EU average.

The GDP-proportionate value of social andpension expenditure has not fallen to under thepeak in 2006 despite the measures taken so far,as a consequence of which its share in totalexpenditure has been rising continuously, whilewe are still far from the ratio characteristic forEU countries.

After the peak in 2006, the rate of econom-ic functions has been falling slowly and gradu-ally, but is still much higher than the average ofthe old EU countries.

The question furthermore is to establish towhat extent the structure of state expenditurethus developed follows the original target fig-ures of the CP for 2009, and to what extent thedivergences hinder or serve the long-termimplementation of the CP. Considering the lat-ter, we have compared what the appropriationsof the CP were in the field of expenditurereduction for the extent of state functions andwhat of these has been realised in what ways sofar (see Table 5).

Columns 1-4 of the table present the size ofthe state's role in the respective function clus-ters, expressed in GDP percentage: the averagerates of the years 2004–2005 before the CP, thecurrent rates (expected in the year 2008), thetarget set for 2009 in the CP and the appropri-ations in the bill. The last column, in turn,shows the changes in real value in the stateexpenditure on the fields concerned, comparedto 2005, as a result of the measures achieved sofar. On the basis of the data it can be estab-lished that, on the whole, the real value of stateexpenditure is hardly higher than the 2005level, but there are significant structural differ-ences within that.

On the basis of the data presented in thetable, the following conclusions can be made.

It can be established that, with the excep-tion of social security, social expenditure andtransport expenditure, the rates of individualexpenditure categories have changed in thedirection set by the CP.

Albeit slower than set out in the CP, therate of expenditure on the operation of thestate has fallen by 2008, which means a fall of8.4 per cent in real value compared to 2005.(Under the CP, further reduction should takeplace in this field by 2009, which is only partlytargeted by the appropriations for 2009 and its


586

implementation depends also on the final reali-sation of this year's target.)

Expenditure on education will also changein the direction set by the CP if this year'sappropriations are met, whereby the real valuewill be 9 per cent lower than the 2005 level ofexpenditure. And, although we are approachingthe international average this way, from thepoint of view of human resource development,on the other hand, the further reduction tar-geted in the CP is to worsen Hungary's chancesof catching up. The appropriation for 2009 is tokeep this year's expected rate at level.

It is the rate of health care expenditure thathas fallen to the greatest extent, meeting thetargets of the CP, but increasing Hungary's lagbehind the average of the EU 15. It is highlylikely to lead to tensions that the appropria-tions for 2009 further reduce state expenditurein this field, where there has been a loss of 12per cent in real value compared to 2005 already,by another 0.2 percentage points.

The function clusters of social security andsocial expenditure as well as transport expendi-ture have developed contrary to the directionset in the CP. As regards social expenditure, 60per cent of which are constituted by pensionexpenditure, it can be established that, by theend of this year, its real value is to be over 10per cent higher than the 2005 level.

Within the latter, the GDP proportionatevalue of pension expenditure has risen by 1 percentage point and its real value is 14per cent higher than in 2005. There areseveral reasons for the latter: in addition todemographic reasons, more people haveopted for retirement due to the restrictivemeasures and the employment problems,whereby the number of new pensionershas sky-rocketed. Consequently, the rateof pensions established under the newmethodology has increased.The level of family subsidies, transformedin 2006 – by raising family allowances and

Table 5

CHANGES IN THE STRUCTURE OF EXPENDITURE AND THE TARGETS OF THE CONVERGENCEPROGRAMME FOR THE YEAR 2009

Key state functions average, fact, expectation*, CP, expectation**, 20082004–2005 2007 2008 2009 2009 expectation/2005

in GDP percentage, current prices volume indexF1+F2+F3 Operation of the state 8.5 8.2 7.5 6.1 6.9 91.6

F4 Education 6.4 6.1 5.6 5.2 5.6 91.1

F5 Health care 5.2 4.6 4.5 4.2 4.3 88.2

F6 Social security

and welfare expenditure 15.9 16.8 17.1 16.5 17.0 110.9

including: pensions 9.0 9.7 10.0 9.7 10.1 114.1

family subsidies 1.5 2.0 1.9 1.9 1.9 138.5

F9-F14 Economic 6.5 7.7 7.1 6.4 6.9 108.8

including: F12 Transport 2.6 4.0 3.1 2.5 3.2 115.1

including: F14 Environment protection 0.7 0.9 1.0 1.1 1.0 150.5

F1. State debt management 4.3 4.0 4.2 3.7 4.0 105.1Total expenditure 50.7 51.1 50.2 47.6 49.1 101.8

* Own estimation

** Under the second budget bill submitted. i.e. data do not yet reflect the reduction of expenditure decided by the government after submitting the bill.

Source: Ministry of finance. cash flow-oriented data


587

partly replacing tax allowances thereby –was to be sustained even under the CP,which is what is expressed by the growthin real value.

The appropriations for 2009 do not include areduction; moreover, a further increase of 0.1percentage point was to be implemented.Taking the measures announced would result ina reduction corresponding to GDP 0.5 per centin pension expenditure.

Through the realisation of unimplementedprojects, the weight of environment protectionis intended to grow: thus, if this year's appro-priations were met according to estimations,there would be an increase of over 50 per centin this field in real value, compared to the levelin 2005. The appropriations for 2009 in GDPpercentage keep this direction at level, withoutincreasing it as intended by the CP.

Finally it can be established that the rate ofexpenditure on transport boosted by themotorway construction in 2006, has beendecreasing much slower than targeted by theCP. Contrary to the CP targets, the appropria-tions for 2009 still expect further increase.

THE MOST SERIOUS RISKS IN THE SYSTEM OF CONDITIONS OF THE 2009BUDGET

Demand risks

Under the predictions for 2009, the worldeconomy is to be characterised by a slowdownin the growth rate. Foreign demand forHungarian products has shown considerableweakening, which means a much more restrict-ed contribution to economic growth thanbefore. It poses special danger that, in theHungarian export structure, the rate of prod-ucts that consumers typically purchase onloans is very high.

From the point of view of fostering growth,

the role of state orders in Hungary is impor-tant. In a European comparison, the volume ofstate demand in Hungary can be consideredhigh. In 2009, the intended amendment of gen-eral government expenditure is to reduce thesize of the 'state market' and is to change thestructure thereof in the direction of a decreas-ing rate of capital expenditure. While the inten-tion to shrink the state market can be consid-ered justified on the basis of international com-parison, regarding its direct impact on econom-ic growth, however, both changes can beviewed as unfavourable. From the sources ofdevelopment, the amount of subsidies from theEU has been rising dynamically, while the rateof domestic subsidies has been significantlyfalling. By today, it is the efficient and timeproportionate use of EU sources that hasbecome the most important growth factor ofthe Hungarian economy. The model calcula-tions made during the preparation of this studyjustify that the failure to use these subsidies ortheir less efficient utilisation may retardHungary's economic development to a sensibleextent.

Analysing the factors affecting householdconsumption expenditure, the study establish-es that the 4.3 per cent inflation predictionlooks realistic, although there is a risk thatactual inflation will exceed this extent by some0.5 percentage points. At the same time, thereis also a chance for a divergence in the otherdirection since foreign inflation pressure is toease as a consequence of the world economicrecession. In the competition sphere, thegrowth dynamic of average earnings is likely toexceed the inflation rate, while the volume ofearnings is to shrink as a consequence of a fallin employment. This, as well as a shrink inhousehold loans is to reduce household expen-diture on consumption. As a consequence ofthe recession, it is only in the case of invest-ment financed from EU subsidies wheregrowth can be expected. Domestic use is thus


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not expected to rise considerably, i.e. will beunable to contribute to the growth of theHungarian economy at a significant extent.

RISKS ORIGINATING IN THE OPERATIONOF THE RESPECTIVE FIELDS OF ECONOMY

According to the contracted indicator of IMDWorld Competitiveness Yearbook, Hungary hasfallen further in the competitiveness ranking.From the component indicators making up thecontracted indicator, it was in the fields of gov-ernment efficiency and business efficiencywhere the backlog was the greatest. For improv-ing economic competitiveness and creating theconditions necessary for long-term growth, it isindispensable to establish an efficient govern-ment sector and modernise public finances.

Raising the standard of employment is a keyissue of future economic growth. From the –structural and quality – side of labour supply,the conditions for fast economic growth aremissing. Young people's labour supply is able tocontribute to the dynamisation of the economyto a very small extent only. A significant part ofthe unemployed do not represent qualitylabour reserves for enhancing employment. Asa phenomenon contrary to the tendencies ofthe past few years, the standard of economicactivity has fallen again. For the short-termmitigation of unemployment-related problems,the Hungarian employment policy spendsextremely high amounts, in an internationalcomparison, on the subsidisation of variousforms of temporary public employment. Theseare of extremely poor efficiency as regards thepermanent employment of those concernedand, at the same time, withdraw sources fromthe financing of active employment politicalmeans of higher efficiency. The mitigation ofthe employment impacts of the developingrecession makes it necessary to re-evaluate thepriorities of the employment policy.

The withdrawal of the proposals amendingtaxation and contribution payment for the year2009 is expected to boost general governmentrevenues by HUF 140 bn compared to theoriginal budget bill but, at the same time, it isto raise GDP-proportionate income centralisa-tion by 0.6 per cent. The burden on labour isnot to be eased and this will adversely affect thecompetitiveness of Hungarian enterprises.

Our survey conducted among local govern-ments of settlements with a population ofunder 5,000 inhabitants in summer 2008revealed that the scarcity of sources has been a“normal” characteristic feature of the systemfor almost one and a half decades now, yet,local governments are usually able to overcomeliquidity problems. It is only a few per cent oflocal governments that are close to insolvency.

The fast increase in bond issuing by localgovernments poses a serious financial risk. Oursurveys so far have indicated that this has nodirect correlation with the local governmentprojects approved and subsidised from EUsources. A significant part of the bonds issuedhas resulted in the boost of the deposit andstate security stocks of local governments.Through this financial transaction, local gov-ernments wish to improve their financial liq-uidity, adding to future commitments. Theabsorption of EU sources by the local govern-ment sector poses significant planning risk.The reservation of the money assets comingfrom bond issuing may result in a “surprise”investment boom by local governments in thecoming two years.

There are also significant reserves in therenewal of the local government system.Mitigating the maximalism of the professionalor sectoral laws specifying the rules on howobligatory tasks should be met and workingout a transparent, predictable and simplesource regulation system along with it couldsignificantly improve the operation of localgovernments.


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The solution of the tasks revised in the studyby itself demands the establishment of anational economic planning system. The latteris also made necessary by the general catch-upcircumstances and requirements of the econo-my and the experience of the operation of eco-nomic political decision making. Consideringall the above, the study advises to embark uponestablishing a national economic planning sys-tem. The most important characteristic of thesystem to be established is that the institution-al harmony of real development and financialplanning should be guaranteed.

THE SCOPE OF PRESERVING BUDGETBALANCE AND FOSTERING ECONOMICGROWTH

Risks directly affecting the budget balance

On the basis of analyses, we established inSeptember 2008 already that there was seriousrisk that, in 2009, economic growth inHungary would fall significantly short of the 3per cent of the government predictions servingas the basis for the original budget bill.Considering the factors presented, the globalmoney market crisis first of all, the exportdynamic is likely to fall short of even the rele-

vant government predictions. As a conse-quence of the slowdown in the growth ofexports, the standard of employment is to fall,which, in turn, is to involve a shrink in the vol-ume of earnings. The stricter conditions ofloaning are to significantly reduce householdconsumption and entrepreneurial investmentexpenditure.

The 1 per cent lower than planned GDPgrowth – depending on the composition of thechange – is to reduce general government rev-enues by some GDP 0.4 per cent. The nominalrate of this certainly depends on the develop-ment of prices and earnings. During our analy-ses, we have come to the conclusion that it wasnot realistic to expect that, due to the signifi-cantly higher than planned inflation, therewould be significant extra revenues for thebudget. The same holds for the revenueincreasing role of earnings and entrepreneurialincomes also. Accordingly, the most significantmacroeconomic risk for the budget balance isthe lower than estimated economic growth.Therefore, we have asked the question to whatextent the reserves appropriated in the originalbudget bill are able to counterbalance this risk.The actual budget reserves of 2007 and 2008(not including special reserves) and theplanned appropriations for 2009 are sum-marised in Table 6.

Table 6

BALANCE RESERVES* IN THE CENTRAL BUDGET(HUF billion)

Description 2007 2008 2009Chapter balance reserves 80.3 88.8

Blocked under Art. 50 + Enc. 18 75.6

General reserves 42.2 46.7 56.5

Central balances reserves 50.0 20.0 78.0

Total 172.5 155.5 210.1

in GDP percentage 0.7 0.6 0.8

Total (without blocking) 172.5 155.5 134.5

in GDP percentage 0.7 0.6 0.5

* without special reserves


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The table implies as if the reserves of theyear 2009 would rise compared to the 2008budget, their volume reaching GDP 0.7 percent once again. In reality, however, theblocked chapter balance reserves of the year2009 cannot be considered reserves in the tra-ditional sense of the word since their subsidis-ation coverage is not provided by the bill.Accordingly, these cannot be considered as bal-ance reserves, because of which the level ofactual reserves is only GDP 0.5 per cent. Thesereserves – also considering that general reservesserve other goals as well – are insufficient forthe compensation for the loss of revenues ifGDP falls behind the planned 3 per cent rate bymore than 1 per cent.

It was pointed out at the beginning of thisstudy that SAO-RDI does not make predic-tions but prepares risk analyses. It was there-fore not with the intention to forecast but forthe presentation of the volume of risks that wemade the following calculation: how high rev-enue deficiency was there, compared to the 3 per cent GDP growth, in the case of a lack ofGDP growth (i.e. of 0–0.5 per cent growth), tobe counterbalanced so that the budget deficittarget could be met. In order to estimate this,we assumed a scenario in which

• there is a significant slowdown in exportdynamics, which involves a slowdown alsoin the growth of imports. The growth ofimports rises slightly higher than that ofexports;

• inflation stays in the 4.0–4.6 band;• there is hardly any rise in domestic use,

sinceaverage earnings (as a consequence ofthe base effect primarily) increase at arate slightly above the inflation rate,the rate of employment falls by 1.5–2.0per cent,in both consumption and investmentexpenditure, the rate of loans decreasessignificantly,

pensions rise at the rate specified by thelaw, while other social allowances riseaccording to the planned inflation rate,there is a slight rise in communal con-sumption,the use of EU-sources reaches theplanned level;

• as a consequence of the lower importdemand of the slightly rising domestic use,we expect a decreasing foreign trade(export) surplus.

The results of the calculations made basedon the assumptions are summarised in Table 7.It can be seen that, in the case of such develop-ment in the GDP, budget revenues would beHUF 350 bn lower than in the case of GDP 3 per cent growth. In addition, the rising costsof state debt financing should also be consid-ered3 (some HUF 120 billion), as well as theextra expenditure due to the rise in unemploy-ment (HUF 50–70 bn). Accordingly, as a con-sequence of the international money marketcrisis, the position of the state budget will dete-riorate by HUF 500–550 billion in the case of alack of GDP growth due to adverse processesin 2009.

So as to retain confidence in the Hungarianeconomy it is essential that the deficit targetsof next year's budget should correspond tothose set in the CP for 2009 or, if possible,should be more favourable than those, and thatthese targets should be well grounded by bud-get correlations. In the current insecure eco-nomic situation, we have considered it especial-ly important to increase real balance reserves toan amount corresponding to at least GDP 1 percent. Reallocating some of the planned targetreserves to the general budget reserves and cre-ating subsidisation coverage for the blockedchapter balance reserves (along with the pro-portionate reduction of other subsidisationappropriations) would serve the above goal.

A few days after the publication of the SAO-RDI study, the government submitted to the


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National Assembly a new budget bill based onnew macro economic predictions, shortly afterwhich it was compelled to revise its macroeco-nomic predictions and work out an amendmentpackage drastically reducing budget expendi-ture. The main indicator figures of the govern-ment's macroeconomic predictions attached tothe second budget bill submitted as well asthose of the predictions amended thereafter aresummarised in Table 8, with the risk analysisalternatives of SAO-RDI added.

The comparison of the government's macro-economic course serving as the basis for thesecond budget bill and the “0” growth riskanalysis alternative of SAO-RDI highlights theinconsistency of the macroeconomic courserelying on the government predictions. The “0”alternative of SAO-RDI namely indicates that acourse like this involves a loss of general gov-ernment revenues of over HUF 100 bn, whichmust be counterbalanced by reducing expendi-tures. This, in turn, results in constrainingdomestic use, i.e. it involves a further economic

slowdown. It seems that those working out thegovernment predictions became aware of thisonly when the government actually decided onthe greatest items of expenditure (suspending13th month's salary in the public sector, settinga ceiling for the 13th month's pension). Thus,the government was forced to pass new macro-economic predictions, based on the expectationof a 1 per cent fall in GDP. The comparison ofthe main indicator figures of the original andthe amended government predictions clearlyshows that the difference is not in the estima-tion of the expected export dynamics, since thedifference here is only 0.2 per cent. What sim-ply happened was that the original predictionsignored the negative impact of the forced reduc-tion of expenditures on domestic use and, throughthis, on economic growth.

For the presentation of the size of risks, wehave also examined the macroeconomic coursebased on the amended government predictions.This prediction scenario is based on the follow-ing main assumptions.

Table 7

THE MACROECONOMIC PARAMETERS OF A “0” ECONOMIC GROWTH ALTERNATIVE FOR 2009

Description 2008,* 2009, 2008,* 2009,Budget submitted “0” growth

Consumer price-index, percentage 6.5 4.3 6.5 4.3 – 4.5

Change in number of employees, percentage –0.7 0.4 –0.7 –1.5 – –2.0

Investment rate, in GDP percentage 20.6 21.1 20.6 20.9The individual items of GDP-bbalance, change in percentage, unchanged prices

GDP growth in previous year’s price, percentage 2.4 3.0 1.9 0 – 0.5

Household consumption expenditure 1.2 2.2 1.0 0 – 1.0

Household consumption total 0.5 1.0 0.3 0.1 – 0.9

Communal consumption –3.5 0.8 –3.5 0.5 – 0.7

Investment 2.0 6.0 1.5 2.0

Domestic use 1.7 2.6 1.4 0.4 – 0.9

Export of products and services 9.5 8.0 8.0 5.0

Import of products and services 8.9 7.6 7.5 5.5 – 6.0

GDP value in current prices, HUF bn 27 380 29 110 27 261 28 230

GDP-loss 119 880

Loss of general government revenue approximately 40 approximately 350

* expected performance


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There will be a significant, 3.8 per cent fallin household consumption expenditure, causedby the drastic, 7 percentage point reduction ofthe average gross salary in the public sphereand the – presumed – slowdown in the so fardynamically increasing household loaning. Thenumber of the employed will drop by 0.6 percent.

Investments will fall by almost 1 per cent,as a consequence of development slowdown inthe competition sector.

Export dynamics will fall significantly, to3.9 per cent, which will, in turn, involve a slow-down in the growth of imports. Due to the fallin household consumption, known to be ofhigh import content, however, the slowdown inimports will be higher than in exports, becauseof which export dynamics will exceed importdynamics by 1.5 percentage points.

In relation with the amended macroeconom-ic course of the government, we have formulat-ed the following risks.

The amending proposal does not includenew indicators for the expected performance ofthe year 2008. Therefore, the predictions for2009 can be compared only to the valuesexpected for 2008, included in the secondbudget bill, although some indicator figures(e.g. GDP growth, exports) are likely to be lessfavourable in 2008 already than the predictedfigures attached to the budget bill. Thus, theremay be serious risks involved in the base figuresalready.

From the macroeconomic indicators ofthe year 2009, the prediction of a 0.6 per centfall in the number of the employed “standsout”. The chance of a fall in employment isindeed mitigated by the fact that, in the public

Table 8

THE COMPARISON OF CALCULATED AND CALCULABLE MACROECONOMIC COURSES FOR THE YEAR 2009

2008 2009 2009 2009 2009Description No. 2 budget SAO- MF SAO-

submitted RDI “0” amended RDIGDP growth in previous year’s prices, percetage 1.8 1.2 0.2 –1.0 –1.0

GDP-deflator, percentage 5.2 3.5 3.3 2.75 2.75

Consumer price-index, percentage 6.4 3.9 4.3 4.5 4.5

Public sphere gross average earnings,

percentage 7.1 5.0 n.a. –7.0 –7.0

Change in number of employees, percentage –1.0 –0.6 –2.0 –0.6 –2 – –2.5

Investment rate, percentage 20.6 21.2 21.1 20.9 20.9Individual items of the GDP-bbalance. change in percentage. unchanged prices

Household consumption expenditure 1.1 0.2 0.0 –3.8 –4.3

Household consumption total 0.9 0.3 0.1 –3.1 –3.6

Communal consumption –2.0 0.5 0.7 0.2 0.0

Investment 1.0 4.0 2.0 –0.9 –0.9

Domestic use 2.1 1.1 0.4 –2.2 –2.5

Export of products and services 7.6 4.1 5.0 3.9 3.9

Import of products and services 8.1 4.1 5.5 2.4 2.1

GDP value in current prices, HUF bn 27 220 28 490 28 200 27 690 27 690

GDP/loss compared to budget sumbitted 290 800 800

Loss of general government revenue 116 300–310 320–340


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sphere, further downsizing is not on the agen-da. Due to the fact that the financial crisis hasspread to the real economy at a significant extentand because of the fall in GDP, there is a greatrisk, nevertheless, that the number of theemployed may fall at a much higher extent, by asmuch as 2–2.5 per cent. This will clearly affectthe volume of earnings and, through this,household consumption and budget revenues.(In the competition sphere, employment proj-ects have been proposed, while the extra costsinvolved have not yet appeared in the budgetamendments).

According to our calculations, the gov-ernment predictions assign a demand reducingeffect of only 1 percentage point – some HUF150 bn – to the fall in household loaning, whichseems insufficient, since, prior to the financialcrisis, Hungarian households financed over 10per cent of their consumption from loansalready. The strictening of loaning may thusresult in a much more significant dropback inhousehold consumption than predicted. Ahigher than predicted fall in employment andthe expected drastic fall in loan financing mayresult in a further fall in demand, i.e. a greaterfall in consumption and GDP.

The development of foreign trade turnoveris extremely uncertain. The slowdown in thegrowth of exports may probably be higher thanpredicted by the MF. If domestic use drops atthe rate forecast by the government predictions– in case there is no change in import demand– the 2.4 per cent growth rate predicted forimports seems an overestimation. What ismore, as a consequence of the risks mentionedunder 2 and 3 above, domestic use is likely tofall at even a greater extent, which will result inan even greater slowdown in the growth ofimports. Under the amended government pre-dictions, net exports are to rise considerablycompared to last year, contributing to GDPgrowth by 1.2 percentage points. In our opin-ion, if the 3.9 per cent growth of exports can be

sustained, net exports may rise at an even higherrate as a consequence of a more significant fall indomestic use.

We have tried to numeralise the risks out-lined. The results of this are presented in thelast two columns of Table 8 (MF amended,SAO-RDI). The basis for reference of the cal-culations is the macroeconomic course in thesecond budget bill submitted. First we made acalculation on the extent of fall in the GDP andin general government revenues, in currentprices, due to the latest macroeconomic coursepublished by the government (MF amended).It can be seen from the table that, in this case,the fall in GDP would amount to HUF 800 bn,and this would reduce general government rev-enues in 2009 by some HUF 300–320 bn com-pared to the second budget bill submitted bythe government.

We then numeralised the changes in GDPand general government revenues in the case ofa macroeconomic course resulting in 1 per centfall in GDP, with the risks listed under 1–4 alsoconsidered. The relevant figures are presentedin the column SAO-RDI of the table. Datashow that, also in the case of this macroeco-nomic course, the volume of GDP in 2009would shrink by HUF 800 bn compared to thesecond budget bill submitted, since we havecalculated with the same inflation rate4 and fallin GDP. This macro-course would, however,result in a somewhat greater fall in general gov-ernment revenues (HUF 320–340 bn) since,due to the smaller volume of earnings, person-al income tax and contribution revenues wouldbe lower and lower domestic use would reduceconsumption-related tax revenues.

As regards expenditures, the growing costsof public debt financing5 (some HUF 120 bn)as well as the extra costs involved in the rise ofunemployment (HUF 70–90 bn) should alsobe considered. Accordingly, in case the amend-ed macroeconomic predictions of the MF cametrue, the general government position would be


594

HUF 500–520 bn, and, with the risks aboveconsidered as well, HUF 520–540 bn lowerthan the values specified in the budget bill sub-mitted.

Due to the great uncertainty related to thepotential macroeconomic courses, the possibil-ity of an even greater fall in export dynamicscannot be excluded, either. As a consequence,there may be an even greater fall – possibly 2 per cent – in economic growth. In the case ofsuch a course, the volume of GDP in 2009would shrink by some HUF 1,000, and that ofgeneral government revenues by HUF 400–420bn. (A further fall of 1 per cent in GDP woulddeteriorate the balance, according to our calcu-lations, by HUF 610–620 bn compared to whatis included in the bill.) This danger to the budg-et balance should be paid due attention to espe-cially considering that there are several factors(the shrinking of export markets, major reductionin budget expenditure, the strictening of loaning,fall in employment) causing a major slowdownin economic growth. If the accumulated effectof these is not sufficiently mitigated, theHungarian economy may get into a recessionspiral which, through the decrease of generalgovernment revenues, may even endangerbudget balance. There are several signs suggest-ing that these factors were not given their dueweight when the government's macroeconomicpredictions were worked out, because of whichthere is also a risk of curbing the economy.

Summarising the conclusions made from thecomparative analysis of the main parameters ofthe macroeconomic courses serving as the basisfor budget planning, it can be established thatthe new, amended macroeconomic course ofthe financial government counts with the worldeconomic realities at a greater extent, and – con-sidering the expectations of IMF as well – itsets out a significant reduction in budgetexpenditure. Accordingly, the direct budgetbalance risks revealed in the SAO-RDI studyhave fallen significantly. At the same time, the

uncertainties prevailing in the real processes of theeconomy – economic growth primarily – have notyet been explored successfully and reassuringly, asregards their social-economic effects, and nomeasures have thus been outlined for their miti-gation as yet.

The “independent” scope of development of the Hungarianeconomy

In the current situation of the world economy,the question to what extent the economicrecession affecting the respective Hungarianexport markets and the slowdown of economicgrowth in the European Union will limit thegrowth perspectives on the Hungarian econo-my, arises especially sharply. The survey of thedevelopment trends of EU member statesreveals interesting correlations. Regarding theissue of catch-up, backlog or simultaneousdevelopment, it is worth considering the GDPgrowth average of the EU-27, the data of thecountries with the fastest growth rates and theindicators of those with the slowest pace ofdevelopment (see Table 9).

Examining the growth courses of the pasthalf a decade, the following conclusions can bemade from the point of view of the Hungarianmacroeconomic scope.

In the EU, the difference between thecountries with the fastest and slowest paces ofdevelopment has been permanently 8–10 per-centage points.

It is the biggest (and at the same time high-ly developed) countries that determine theaverage. The economic structure of these coun-tries is stable. Even if there are phases ofgrowth and recession, the extreme values ofthese are not to compare to those of thegrowth courses of countries in transition.

In the period presented, the fastest grow-ing countries are all accession countries in the


595

phase of catching up. Every year of the periodexamined, Baltic states produced above 7 percent growth rate, and the annual levels of devel-opment of Slovakia and Romania were alsohigh.

The predictions for the years 2008–2009reflect a slowdown in the growth rate of acces-sion countries that have so far been charac-terised by a fast catch-up pace.

From the aspect of the Hungarian economicscope, the above means that the catch-up paceof new member states is significantly influ-enced by all-European growth but its frame-work is not limited by it: the fact that there isopportunity for “ an upward break-out” is provenby the economic course of the countries men-tioned. Consequently, for the countries in thecatch-up process, the role of other factors inaddition to the EU growth rate is also of pri-mary importance. One of these factors, webelieve, is the strength of the inner economy(especially that of domestic small and mediumenterprises) and the other is the performance ofthe transnational companies present in the econo-my of the country concerned.

In the examination of the factors influencingthe macroeconomic scope it is determinativewhether it is short-term or long-term correlationsthat are examined. When determining the cur-rent scope, economic policy certainly considers

the most important components of the currentstate. The exclusiveness of short-term charac-teristics may, however, conceal factors thatmean long-term trends characteristic not onlyfor the past but important components offuture development also. Keeping the require-ments currently arising for the economic poli-cy in mind, we shall now consider the longer-term correlations of the openness of theHungarian economy.

The openness of the Hungarian economyhas been in the centre of economic politicalthinking and of the Hungarian economic poli-cy for decades. The export/GDP opennessindicator6 of Hungary (taking forint data incurrent prices as a basis) was somewhat over 30per cent at the time of the political change;until 1995, it rose only by a few percentagepoints, while in 1998, it reached 50 per cent.The forint-based openness indicator calculatedfor 2006 was 77 per cent already.7

In the years 2004, 2006 and 2007, the foreigntrade growth rate exceeded the previous year'srate by 18, 18 and 16 per cent respectively. In2007, its absolute value was Euro 68.6 bn. Thisdid not only involve an increase in openness,but also a change in the rate of foreign tradeand GDP growth; moreover, a change in thecontent of the correlation itself.

In the period of the transformation change

Table 9

THE GROWTH INDICATORS OF THE THREE EU COUNTRIES WITH THE HIGHEST AND LOWESTGROWTH RATES AND THE AVERAGE OF THE EU-27

(GDP growth in previous year’s percentage)

Description 2003 2004 2005 2006 2007The three highest growth rates 10.3 8.7 10.6 12.2 10.4

7.2 8.5 10.2 11.2 10.3

7.2 8.3 7.9 8.5 8.8Average 1.3 2.5 1.9 3.1 2.8

The three lowest growth rates –0.2 0.2 0.8 1.3 1.3

–0.3 1.1 0.9 1.8 1.5

–0.8 1.5 1.5 2.0 1.8

Source: Compiled based on the data of the Spring 2008, Economic Forecast of the European Commission


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following the political change, the fall in or thedisappearance of former COMECON-exportsmade production capacities superfluous andwas one of the direct causes of the fall in pro-duction, while the outdated structure of pro-duction certainly limited the goods base ofexports. In 1993, Hungarian export was exact-ly 20 per cent lower than the level of the year1989 before the political change.

In 1993, the fall in GDP was practically thesame as the fall in export: the GDP level was82 per cent of that in 1989. At the time, con-sidering the weakness of the Hungariandomestic market as well, it was formulated as aclear economic political goal that Hungarianeconomic growth should be based on thegrowth of export. The separation of the cours-es of GDP and foreign trade started in theyears following the political change and gotincreasingly stronger by the continuouslygrowing scope of multinational companies inHungary (see Figure 1).8

The primary explanation for the divergenceof the development courses of the two fieldsis that a significant part of Hungarian export isin fact only very loosely related to theHungarian economy, to the inner productionprocesses. The reason for this is not only theincreasing role of foreign operating capitalitself, but also the fact that, in Hungary, agreat proportion of the activities of foreign-owned multinational companies has not becomean integral part of the inner economy.Consequently, in determining the macroeco-nomic scope of the 2009 budget, the developmentof export is important, but its role as regards itsweight is different from what it was one or oneand a half decades ago. Some 80 per cent ofHungarian export is concentrated at foreign-owned multinational companies. This export isbased, to a significant extent, not on domesticproduction or the creation of Hungarian addedvalue, but is ultimately based on import pur-chased for the sake of export.

Chart 1

THE DIVERTING TREND LINES OF HUNGARIAN GDP AND EXPORT(change to previous year, percentage)

Source: CSO Statistical Yearbook of Hungary 2006, pp. 199, 249, The CSO reports 2008/1, as well as CSO Foreign Trade Statistical Yearbook(various years)

2001 2002 2003 2004 2005 2006 2007

GDP

20

18

16

14

12

10

8

6

4

2

0

Export


597

The analysis of the statistical data presentedis suitable for the formulation of a few remarks:the openness of Hungary, its dependence onthe international economy has furtherincreased in the almost two decades since thepolitical change. Today, this openness is, howev-er, reflected not only or not primarily in the for-eign trade turnover, but in the presence, produc-tion and trade of transnational companies. Theinternational connections between countriesrealised through foreign trade is complementedand made stronger by the direct influence ofoperating capital movements in a way that therole of transnational companies is increasinglysignificant in foreign trade itself. Thus, whenestimating the macroeconomic scope of bud-get planning, in addition to processes in foreigntrade, the changes, limitations and opportuni-ties arising in the corporate sphere should alsobe considered.

Economic growth cannot be exclusively ordecisively connected to export growth given thecurrent structure thereof. The economic politicalgoal may be to increase Hungarian added valuewithin the import. This requires the closerintegration of transnational companies intothe Hungarian economy on the one hand and(parallel with the former and connected to it)the strengthening of the Hungarian small andmedium enterprise sector and the increase ofits export on the other hand. It provides sig-nificant growth reserves in general that themass characteristics of production are increas-ingly less determinative for the rate of eco-nomic growth; instead, it is increasing theadded value that is gaining a growing role. Theadded value, as a performance indicator, getsan increasing role also in the self-evaluation ofcompanies. Actors of the competition sectorhave realised that, given rising raw materialand energy costs, their market positions canbe protected only by increasing the knowl-edge content incorporated in the product(production procedures), the almost exclusive

way of this is strengthening innovative atti-tude and behaviour.

The above presented fact according to whichHungarian export is, to a significant extent,based not on domestic production orHungarian added value but ultimately onimports purchased for the sake of exports,throws different light on the growth effect ofthe slowdown in the growth of export. It can benamely assumed that the slowdown in the exportsof certain branches dominated by multinationalcompanies will primarily result in a similar fallin the imports used for the exports but will only toa limited extent cause a reduction in GDP andunemployment. Unfortunately, on the basis ofour current knowledge, the indirect negativeeffects are not to be estimated at all.

The other conclusion to be made from thetendency presented is that, due to the highimport content of the export, a relatively high vol-ume of exports is necessary to avoid that theimport necessary for domestic use could result ina negative foreign trade balance. There is thus agreat risk that, if domestic use grows – even ata low rate – and export dynamics fall at thesame time, the foreign trade balance will turninto the negative once again. It is this risk thatwe shall examine in the next chapter.

The risks of growth based on domestic consumption

Emphasising the change of content of export-oriented growth does not mean at all that thegrowth of the Hungarian economy should beunilaterally based on the growth of domesticconsumption. The main reason against that isthat the growth of domestic purchase power doesnot necessarily lead to growing domestic con-sumption if the rate of import rises within con-sumption and results in the deterioration of thebalance of payment position. The import rateof products in retail trade has grown signifi-


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cantly in the past decade. The growing open-ness of markets is a productivity increasing fac-tor on the one hand while, on the other hand,the question arises when the replacement ofHungarian products with those of import ori-gin reaches a level when it causes a reduction inthe level of Hungarian production, potentiallygenerating foreign balance problems. In orderto numeralise this danger, we have commis-sioned ECOSTAT to perform model calcula-tions.

We actually examined what macroeconomiceffects it would generate if, in 2009, the importdemand of consumption rose by 5 percentagepoints compared to the normal state and thisrate continued in 2010–2011 as well. Thisrequired a new import demand function to beinserted into the ECOTREND-model as thefunction of the volume change of items of ulti-mate use. In this version, GDP is determinedthrough the items of ultimate use and thedevelopment of imports.

The result of the model calculation was thata growth in the import demand of consump-tion directly increases import, while it has nodirect impact on export. The consequence ofthis is the deterioration of the balance of pay-ments as well as slower growth compared tothe normal scenario. It has an indirect effect onthe other indicators as well, which are of a less-er extent, however. The growth in importdemand assumed for 2009 in this scenario rais-es the import volume level and, since theserates are to remain high later on, import willstabilise at a higher level. According to the modelcalculations, the growth rate of import will be 2.7percentage points higher in 2009, in 2010–2011,however, it will not be significantly different fromthe values calculated for the normal state. Theexplanation for the latter is that, after 2009,there is no new “import shock”, i.e. the growthcompared to the higher import level estab-lished by then will essentially be the same asthe earlier – what is more, it was actually calcu-

lated to be a little lower than that. Althoughthe difference is insignificant, it still requires anexplanation: in 2009, the import surplus gener-ates some slowdown in GDP growth and theslower growth, in turn, induces a lower importdemand. What is more, the growth sacrifice ispermanent- although its rate is 0.1–0.2 percent-age points only – and because of this it has areducing effect on import.

The growth in the import demand of con-sumption has a double effect on the foreigntrade and current payment balances. On theone hand, the growth in import directly deteri-orates both balances, while the above men-tioned little slowdown somewhat improves thebalances in 2010–2011.

The growth in demand has a clearly negativeeffect on the general government balance. Themain reason for this is that the tax content ofimports is lower than that of production ofdomestic origin. This effect is certainly madestronger by the loss of revenues due to theslower growth.

Thus, the basic conclusion of the model pay-ments is that economic growth based on domes-tic consumption may be successful only if thecompetitiveness of Hungarian enterprisesimproves at least at the domestic market. In thecontrary case, import demand and the importvolume itself will rise, because of which GDPgrowth will slow down and both the foreigneconomic and the general government balanceswill deteriorate.

STATEMENTS OF SUMMARY

On the basis of the analysis of the study, wehave drawn decision makers' attention to thefollowing macroeconomic risks related to the2009 budget bill.

The greatest risk is posed by the fact that, dueto the significantly slower than predicted econom-ic growth, budget revenues are to fall short of the


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planned level by several hundreds of billionforints while, due to the world economicchanges, some items of expenditure (tax ser-vice, unemployment-related costs) are to rise.In order to sustain balance targets, it is neces-sary to adjust budget expenditure and revenuesto the new situation and, considering the high-level risk, it is advisable to raise actual budget bal-ance reserves to a sum corresponding at least GDP 1 per cent.

As a consequence of decreasing exportdynamics, the coverage for the imports requiredby growing domestic consumption is not provid-ed, i.e. spurring domestic use by artificial meanswould lead to a negative foreign trade balanceonce again.

There is a realistic chance for an over 2 percent fall in inflation, so, if the rise of averageearnings in the competition sphere (includingthe carry-over effects of this year's interimsalary rises) is not adjusted to this, real earningswill rise at a rate unjustifiable by economicgrowth, which may, once again, lead to animbalance of foreign trade. Here it should beconsidered also, however, that the rate of loansin household purchase is expected to fall signifi-cantly next year. This and the over-restriction ofsalary rises could lead to a considerable fall inhousehold consumption expenditure, whichwill tone down economic growth and may gen-erate a negative growth spiral.

Without increasing the competitiveness ofHungarian enterprises, export dynamics may fallvery significantly and, due to the increasingimport competition, the import demand ofdomestic use may also rise. Both of the abovewould further reduce economic growth andgeneral government revenues. Accordingly, theaspects of the competitiveness of Hungarianenterprises must be maximally considered whentaking measures to improve the general govern-ment balance since, through this, the import

demand of domestic use could be mitigated. Inour study, we pointed out that the balance tar-gets set in the CP have been surpassed, but thiscould be achieved by increasing income cen-tralisation only. The failure to implement theamendment of tax and contribution lawsincreases income centralisation by GDP 0.6compared to the planned level. This worsensthe competitiveness of Hungarian enterprisesand, through this, the chances of sustainingeconomic growth.

The change in the structure of public expen-ditures does not strengthen economic growth,either, since the rate of development-relatedexpenditures has not grown; moreover, underthe government's plans, despite the significantdevelopments to be implemented through EUsubsidies, it is not to rise in years to come,either. The situation is further shaded by thefact that, in 2007–2008, the implementation ofEU-subsidised projects has progressed at amuch lower pace than planned. From the aspectof next year's economic growth, the possibly fullutilisation of EU sources is a question of keyimportance.

Considering the above, the conclusion arisesthat the CP needs a thorough revision. The bal-ance targets of the CP must not be given up;moreover, on the basis of the tighter balancereached in 2007 and 2008, and with regard tothe difficulties in public debt financing, itseems justifiable to set a tighter target for 2009.By today, it has become obvious that the eco-nomic course on which the CP was based is notrealistic. The expected lower economic ratemakes the revision of GDP-proportionate rev-enue and expenditure rates necessary. Whentransforming the budget structure, priority mustbe given to measures fostering the competitivenessof enterprises, economic growth and the preserva-tion of work places so that economic recessioncould be avoided.


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1 The government predictions serving as the basis forthe second budget bill submitted expect only 1.8 percent economic growth in 2008.

2 The situation is similar as regards the result-orientedESA-balance, in the case of which the factual num-bers of 2007 reveal only 5 per cent deficit, comparedto which, again, an improvement of 1 percentagepoint is necessary so as to attain the planned deficitof 4 per cent.

3 This is related directly to the international moneymarket crisis rather than the slowdown in economicgrowth. Our calculations were based on the assump-tion that there would be approximately 10 per centrise in state-debt related costs.

4 We do not consider it sufficiently well grounded thatthe government's inflation prediction has risen from3.9 per cent to 4.5 per cent. At the same time, boththese values are within the band of 3.8–4.8 per centheld for probable by the SAO-RDI study, because ofwhich we have accepted the government predictionof 4.5 per cent as the basis for calculations.

5 This is not related to the slowdown of economicgrowth but is a direct consequence of the impact of

the international money market crisis. We haveassumed that the costs related to public debt wouldrise by 10 per cent approximately.

6 Despite the extremely different methods of calculat-ing the indicator, the uncertainty of long-term timerows generated exactly by the changes in methods,the comparison limits of respective periods and theincreasingly stronger distorting speculative effectson exchange rates it can be established clearly thatthe openness of Hungary measured through the vol-ume of its foreign trade has increased continuouslyand extremely forcefully in the almost two decadessince the political change.

7 Source: The values were calculated on the basis of:Central Statistical Office (KSH/CSO) The NationalAccounts of Hungary, 1996–1998, Budapest, 2000;The National Accounts of Hungary, 2005–2006,Budapest, 2008 The figure of exports includes prod-uct – and service exports.

8 The expansion of the production and the related for-eign trade activity of companies operating in customfree trade zones, which began in 1993 already, was ofspecial significance in this process.

NOTES

LITERATURE

BÁGER, G. – HAMZA, L. – KOVÁCS, R.- PULAY, GY. –VIGVÁRI, A. (2008): Macroeconomic risk analysis andimpact survey, Ellenõrzési Figyelõ, Issue 1, pp. 33–37

BÁGER, G. – PULAY, GY. (2008): Analysis of themacroeconomic risks of budgeting (Method andvalue), Public Finance Quarterly, Issue 3, pp. 384–401

PRÁGER, L.: The role of world economic processesin the growth and balance course of the Hungarianeconomy (manuscript, State Audit Office Research andDevelopment Institute, Budapest, August 2008)

An evaluative study on a few correlations of themacroeconomic foundations of the 2008 budget bill(State Audit Office, October 2007)

An evaluative study on a few correlations of themacroeconomic scope of budget planning for 2009,State Audit Office Research and Development Institute,Budapest, May 2008

National Accounts of Hungary 2005–2006, Budapest,May 2007

Statistical Yearbook of Hungary, Central StatisticalOffice, 2006, p. 249; The CSO reports, 2008/1, p. 11

The CSO reports: Economy and Society, 2008/7,Budapest, 26 September


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T

László Csaba

The new kind of macroeconomic populism1

This paper is intended to examine why newlygained EU membership failed to trigger powerfulstructural reforms in new member states. Whatevolved in these countries instead was a non-etatist economic policy that sharply contradictedwith the requirements of a single currency though.We suppose the ultimate reason could be that eco-nomic policy in these countries was limited to theway-too-perfect application of basic macroeco-nomic textbook strategies. As a consequence,national governments lost all tools and willing-ness to resolve economic overheating in time.Besides listing a number of explanatory factors,we also make an attempt to draw theoretical con-clusions that stretch beyond the scope of econom-ic policy.

Having lost the headway it had upon thechange of political system in 1989-1990 andnow struggling in a trap of lasting economicdeceleration and financial disequilibrium, todayHungary visibly differs from its peers, i.e.transformed countries that joined the EU withHungary. While a number of studies were writ-ten on the reasons of Hungary's derailment(Muraközy ed., 2007), Hungarian public lifeseems to have been taken over by self-pity andintroversion in the meantime. There is hardlyany talk about the fact that the countries whichgrew at an unbelievably high rate at the time ofHungary's slowdown showed the symptoms of

unsustainability (which is considered the origi-nal sin in current economic literature) in2005–2007 already. While the domestic andinternational public and press are under thespell of short-term growth indicators, mindssharpened on economic sciences could wonderwhether the growth trend value of Slovakia andEstonia, countries that overtook Hungary interms of per-capita GDP in 2006 already, canreally stay above 10 per cent per year in thelong run. For this kind of growth can only beachieved by China, with a self-reported per-capita income of USD 2 400 which is one tenthof the respective figures in the aforementionedcountries – in line with the well-known recog-nition of Evsey Domar and later Robert Solow.While we readily admit that for the Hungarianauthor it is perhaps a case of sour grapes, thequestion is still there, as the referenced growththeory principles were not invented in con-junction with transforming economies. What ismore, nobody has proved them wrong in thepast fifty years.

Similarly, it can be pointed out (as not sur-prisingly it has been pointed out by bank ana-lysts already – see Backé et al, 2007; Enoch andÖtker–Robe ed., 2007) that in small and openeconomies like the Baltic and Balkan statesunder our review, growth cannot be independ-ent from the state of the external balance of


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payments and assumes an acceptable disequi-librium thereof – or else their growth could notbe financed anymore. As we know so way toowell from our own economic history, externalfinancial sustainability has a limiting force oneconomic development in the medium and thelong run. Based on commonly accepted rules ofthumb, the deficit should not exceed 5 per centof the GDP for any lasting period of time.2

Instead, what we could see in the Baltic coun-tries in the 2000's was a payment deficitequalling 13–22 per cent of the GDP while theacceleration of the Bulgarian and Romanianeconomies was accompanied by a significantpayment deficit, too. In Bulgaria, according tothe Unicredit review quoted below, the deficitin 2006 was none less than 17.8 per cent of theGDP, then 21.5 per cent in 2007 and will “only”decrease to 14.5 and 11 per cent in 2008 and2009 respectively then it will grow again. Thecorresponding deficit figures in Romania were10.4 per cent of the GDP in 2006, 13.9 per centin 2007, 14.2 per cent in 2008 and 13.5 per centin 2009, signalling that a significant part ofgrowth was based on external resources. Thiswas one of the reasons why it became evident in2007–2008 that despite former expectations,only two countries in the region and the twoislands are actually able to fulfil the require-ments associated with a single currency, whilethe other new entrants cannot – regardless oftheir spectacular growth.

This is more than puzzling, as most expecta-tions upon enlargement predicted that the newmembers will easily meet EMU requirementsalbeit at a high price in terms of growth andmodernisation. It is not surprising at all thatthe fiscal and monetary rules of the EU, whicheven the European Commission warned for in2004, have so little effect on new memberstates. While an analysis of old member states(Gyõrffy, 2007) aptly points out that externalforces are not sufficient if there is no internalcommitment, in the countries reviewed herein

(contrary to the core states of Western Europe)governments enjoyed powerful support fromeconomist professionals and the general publicconcerning issues like price stability, smallergovernment, transparent taxation and thereduction of the welfare state. What is evenmore interesting is whether any agreement orpolicy that emerges from this market-support-ive consensus can lead to East Asian-typefinancial crises – a turmoil characterized by therevaluation of financial values while fundamen-tals seem to be in good shape on the surface – astate that we might as well call a crisis(Lámfalussy, 2008).

A CASE OF EXCESSIVE ADHERENCE TO TEXTBOOK WISDOM

Our hypothesis is as follows: While in2001–2008 Hungary pursued an old-fashionedpopulist policy that not only contradicted witheconomic axioms but considered it a merit todo so, other transforming countries demon-strated a new kind of macroeconomic populismthat involved the plain and direct implementa-tion of all the simplifications presented in ele-mentary economic textbooks (where they areactually valid). The simultaneous serving ofthese textbook-style approaches and politicaltastes led to a situation where governments nolonger have tools to halt certain processes andeven if they recognise a threat they have nomotivation to step on the brakes. The final out-come can be interpreted as the interaction ofthese two circumstances.

We should note that traditional populism asevolved in Latin-America (Kádár, 1977;Dornbusch – Edwards ed., 1990) usuallyattempts to favour the public by manipulatingexpenditures, mainly through targeted alloca-tions and neglecting financial equilibrium up-front. While richness in natural resourcesenabled and enables popularity-seeking via the


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distribution of the related proceeds, a policywhich is usually accompanied by an autocraticpolitical regime (Mehlum et al., 2006; Borkó,2008)3, in the countries we review herein thereare annuities which could be distributed in thismanner. Therefore, the “new feature” in thesecountries is that the “unleashing” of govern-ment spending is more observable on the rev-enue side. On top of all that, central govern-ments cannot and are not willing to slow downor block private consumption after decades ofdeferred consumption. This way, their populistpolicy is less apparent on the expenditure side– it is more tangible on the revenues and regu-lations side. Without attempting to addresseach an every aspect, below we outline a sketchof the underlying components.

The elements of a popularity-seekingeconomic policy

A BOOM DRIVEN BY THE PRIVATE SECTOR AND

PERSONAL CONSUMPTION Analysts of the eco-nomic disequilibrium in the Baltic countriesand in Romania and Bulgaria (Darvas – Szapáry,2008) aptly point out that while in the oldsocialist era it was mainly government over-spending, capital investments and an overheat-ed defence industry that led to an external dis-equilibrium, the boom which evolved in themid-2000's was explicitly driven by the privatesector, in particular by personal consumption.Another special aspect of the situation was thatfiscal policy mostly proved to have no means tohandle the situation. Not least because lendingwas is in the hands of private banks by then, asthey had been sold to foreign owners duringprivatisation. These foreign parent institutionsare subject to the regulations of their homecountry. Their subsidiary's host country hasvery limited means to limit their borrowing andcan only hold the subsidiary accountable forcompliance with basic transparency and cau-

tiousness requirements. The pace and structureof their lending is beyond the control of gov-ernment authorities. This can also be interpret-ed in a way that central banks have lost most oftheir power to shape the monetary base. Uponprivatisation, a significant part of money cre-ation was transferred to these financial institu-tions. With foreign exchange lending, however,they practically bypass the requirements thatare supposed to regulate domestic money sup-ply. Naturally, it remains true that in small andopen economies, the role of monetary policy isbecoming increasingly symbolic – for it is notthe monetary council that keeps the ballrolling, as reflected by the gap between keymoney market interest rates and the rate thatthe internal risk level would justify. Theincreasingly trans-national nature of banks andthe vanishing of clear borderlines betweenbanking and non-banking activities havebecome a major regulatory challenge which isnot limited to transformed countries at all. Thefact that this challenge is unresolved wasalready known before it became a crisis factor(Csaba, 2007, chapter 13).

LET FISCAL POLICY HELP As an obvious nextstep in the process outlined above, it was pro-posed (Backé et al., 2007) to let fiscal policy(the other key area of economic policy) helpmonetary policy to overcome the difficulties. Itmay make sense and there might be many waysof doing it. First, the obviously overheatedgrowth rate in excess of 10 per cent, which isdangerous in sustainability terms, should be(should have been) cooled down with a view totraditional economic considerations. One toolto achieve that is a tax raise. Considering thecondition of the physical infrastructure andpublic institutions in the countries concerned,the resulting revenues could have been spent“unproductively”, i.e. without generating addi-tional growth. There is no doubt that justicereforms lacked by the EU especially in Bulgaria


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and Romania, along with reversing the environ-mental destruction which Baltic countries most-ly inherited from the Soviet era could providesignificant and extensively beneficial publicexpenditure opportunities to foster long-termdevelopment in these states. True, these expen-ditures are less suitable for justifying thenationalist programmes of “catching up withthe West”, i.e. they are not directly convertibleinto political benefits if you like.

It is quite important to acknowledge that inthe case of the Baltic countries, not only fastgrowth but tax reduction and low public bur-dens in general have become national identityshaping factors (Bönker, 2008). This circum-stance explains the lack of will (after twodecades of stagnation in Soviet times and thenduring transformation) to hold back consump-tion-driven growth, or even to apply evidenttax policy means to slow down the economy. Itis remarkable that the stoppage of economicgrowth and the rise of inflation finally occurredunexpectedly in 2008, as these turns were noteven vaguely anticipated in central bank analysespublished in the first 3–4 months of the year. E.g.the chairman of the Latvian national bank4

cited under their achievements that the pay-ment balance deficit decreased from 2007's 26.6per cent p.a. to 19.9 per cent while inflation was13.8 per cent, sovereign debt equalled 60 percent and GDP growth dropped to 3.3 per cent.Similarly, even the Lithuanian central bankwhich had been optimistic at the beginning ofthe year had to report the syndromes of a hardlanding: after GDP the 0.3 per cent GDPgrowth in 2007, the figure shows a decrease of1.5 and 1.8 per cent in 2008 and 2009 respec-tively. At the same time, despite deceleration,the balance of payments deficit remainedextraordinarily high, moving from 13.7 percent p.a. in 2007 to 11.9 in 2008 and to only10.6 per cent in 2009, while inflation remains inthe two-digit range in 2008.5 Finally, decelera-tion is expected to be the lowest in Estonia

which took corrective measures partly on itsown initiative in early 2008. Economic growthis planned at 2 and 3 per cent in 2008 and 2009respectively and the former 6–7 per centgrowth rate is expected to return after that. Inthe meantime, inflation is expected to increasefrom 2007's 6.8 per cent to 9.8 per cent in 2008and then to drop to 4.5 per cent in 2009.According to the central bank's forecast6, thebalance of payments deficit will decrease fromthe extraordinarily high 2007 figure of 15.8 percent to 8.3 per cent in 2008 and then to 6.1 percent in 2009 while the country's external debtwill get stuck at the astounding level of 110 percent/!/.

It is apparent that the overheating of theeconomy led to recession in the first two casesand caused deceleration which lasts longer thanexpected and is aggravated by further risks (thebursting of the real estate bubble, increasinglydifficult access to external financing due to theloss of confidence). It is obvious that when theEuropean Central Bank turned downLithuania's application in 2006 and whenEstonia and Latvia stepped back from acces-sion, the reason was not the one-tenth percent-age point difference, but a realistic evaluation ofthe position of those countries.

A similar situation evolved in Bulgaria wherethe stagnation and consolidation after the late90's was followed by an average growth rate of5.5 per cent in 2001–2005, then 7.1 per cent in2006, 6.2 in 2007 and around 5 per cent in 2008.This growth, however, was accompanied by ageneral government deficit that increased from2004's 1.4 per cent p.a. to 3.4 per cent in 2007while inflation changed from 5.5 per cent in2001–2005 to 7.4 and 7.8 per cent in 2006 and2007 respectively and then grew above 13 percent in the first months of 2008.7 In the mean-time, according to Bulgarian central bank sta-tistics, the country's net external debt totalledto 93.8 per cent of the GDP by the end of April2008. The public sector's share in this figure,


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however, was only 11.4 per cent of the GDP. Inother words, mainly the private sector incurreddebts to foreigners.8 It is clear that theBulgarian government did not hit the budgetarybrakes either while it tolerated (partly underpressure) the excessive indebtedness of the pri-vate sector.

In this respect, Romania was an exception.After the wasted 90's, average GDP growth was5.5 per cent in 2001–2005, 7.9 per cent in 2006,6 per cent in 2007 and decreased only slightlythis year. Inflation peaked at 8.5 per cent in Q12008 and forecasts predict that it will reach theinflationary target of 3.5 per cent by Q4 2009.9

It is a remarkable difference compared to othercountries, however, that Romania's externaldebt reached 29.6 per cent of the GDP in 2006and will only grow to 32.5 per cent in 2008while forecasts do not predict any furtherincrease until 2010. Within this data, the cur-rent 17.2 per cent ratio of the public sector maydecrease to 15.4 per cent of the GDP by201010, meaning that private indebtedness toforeign banks does not exceed the reasonableextent.

GLOBALIZATION AND EUROPEAN INTEGRATION

HAVE PRODUCED DIFFERENT RESULTS THAN

EXPECTED While it brought many benefits forthe countries discussed herein, the dual processof globalisation and European integration hasnot improved stability and competitiveness tothe extent expected by local decision makers.The EU failed to revise cohesion policy andrural development in a way that would haveeliminated the competitive edge of the richestcountries which derives from their superioradministrative capabilities. Expenditure priori-ties have not been realigned along frequentlycited criteria like solidarity and convergence.What is more, bidding and open tendering isemployed more and more extensively whichusually favours more developed core EU mem-bers.

At the same time, new members depicted theEU to their public as an endless source ofabundance. Some politicians may have believedtheir own rhetoric that the influx of EU fundswould automatically have a powerful multipliereffect. Yet if we think of a specific developmentpurpose, be it the construction of mortuariesor the refurbishment of the Academy of Musicbuilding in Budapest, or even the constructionof bridges and motorways, or railway trackrenewals, it would be rather difficult to capturethe direct financial benefit of these projects. A country's ability to attract capital continuesto be determined by the overall economic envi-ronment, the legal framework and the momen-tum/breadth of privatisation. EU membershipdid not add much to any of these. It is interest-ing to see that a pivotal issue upon accession,the regulation of the financial sector which theCommission accepted as EU-compliant in thecase of Hungary performed so poorly in han-dling the effects of the consumption boom thatderived from prosperity and interest conver-gence.11 It is also apparent that economicgrowth is accompanied by external disequilibri-um both in the Baltic and the Balkan countries.This is alarming and obviously unmanageablein the long run, especially in the Baltic stateswhere exports are stagnating.

SINGLE CURRENCY REQUIREMENTS ARE DIFFI-CULT TO MEET Based on the arguments outlinedabove, it is easy to conclude that Baltic andBalkan countries will not be able to meet EMUrequirements either now or in the near future.What it also means is that relatively fast growthdoes not “automatically create” a balancedbudget, exchange rate and price stability andthus interest rate convergence either. What hasbeen proved wrong again is the argument thatprosperity is the best enabler of compliancewith requirements (as cited regularly, especiallyin the debate of the Stability and Growth Pact).This argument is based on the thought that a


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given amount of deficit represents a lower per-centage at the time of high growth, while thegrowth itself means more income for the gen-eral government. This is an excessive simplifi-cation which ultimately reverses the sequence ofcauses and outcomes.

The situation would be just the opposite inboth groups of countries. I.e. if somehow theyhad been able to fulfil expectations of fastEMU accession, the balance of payments limitwould have been eliminated as a consequenceand supposedly the budget equilibrium couldhave been preserved even with fast and sustain-able growth. If so, external indebtedness wouldhave lost significance as it has been known forlong as a barrier to sustainable growth in con-verging countries. Then as a result of all this,the growth-accelerating impact of the EUcould have become lasting and the favourableeffects observed in Spain, Ireland, Greece andFinland could have been dominant (althoughthis is not an automatic consequence as shownby the example of Portugal and Italy).Experience from recent years suggests thatprice stability can only be achieved throughongoing efforts although this is much less recog-nised in converging countries. Therefore, ajoint central bank like the ECB which has high-er credibility and is less exposed to politicalpressure than national banks could haveenabled higher security and cheaper externalfinancing instead of the “hands up” approachthat was actually followed.

THE ROOT CAUSE What is the root cause thenthat these countries were unable to join the Euro-area just in an era of fast growth, even though thebudget was in good shape in the Baltic countriesand it could have been put into order in theBalkan states? We should note that none ofthese scenarios involved an old-fashioned pop-ulist adventure of the Hungarian type.

The most obvious explanation to this wouldbe the prosperity argument, i.e. that fast

growth, especially with a fixed exchange rate(of which Romania is an exception) could havea price-increasing effect. Here we have to notethat this argument (which emerged in conjunc-tion with the Balassa-Samuelson-effect) wouldonly be true if non-elastic prices and especiallycapital influx were not present, if price increas-es were caused by changes in productivity andnot by changes in centrally fixed and regulatedprices which is surely not the case in the coun-tries we discuss herein (Égert et al., 2003). Asconfirmed by the central bank reports refer-enced above, the other source of the priceincrease was the excessive expansion of the mon-etary base fuelled by loans taken out to financethe simultaneous boom of consumption andcapital investments.

From another viewpoint, the inflationarypressure manifests the structural weaknessesand the incompleteness of institutions of trans-formed countries. First, the currency councilmade monetary policy instruments unnecessarywhile the combination of a low IPO rate and thewage pressure make business valuations uncer-tain. The most important factor, however, waspartly the inability and partly the unwillingnessof central governments to hold back aggregatedemand, principally due to political reasons.

IMPLICIT ECONOMIC POLICY As a natural nextstep, it may be helpful to look up the concept ofimplicit economic policy (Szegvári, 1988) again.It is especially useful if there is a veritable gapbetween the declared principles and endeavoursof the government and the priorities it actuallyfollows which is obviously the case in Hungary.Implicit economic policy refers to actually fol-lowed priorities which may not be directlyderivable from official policy declarations.

What it all clearly highlights (and we canprove it with further facts) is that accession tothe Euro-area at the earliest possible date was notthe actual economic policy priority12 in either theBaltic or the Balkan states. Based on recent


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declarations, the same applies to the govern-ments of the Visegrad countries – exceptSlovakia. Is it is well known, the single curren-cy represents a specific economic philosophyand governance practice and not even all coun-tries that established the EMU are always ableto fulfil the related requirements. Therefore,this statement applies to the overall nature ofgovernment policy and it definitely cannot berestricted to the otherwise reasonably impor-tant question whether the individual countriesare approaching the Maastricht criteria or therequirements of the Stability and Growth Pact,or if they are actually moving away from themas we saw in 2005–2008. For the declaration ofquantitative requirements mostly serves themeasurable answering of the credibility ques-tion. The lower the domestic and internationalconfidence in a specific government amongvoters and businesses, the higher the opera-tional significance of quantitative requirementsis. When an overall lack of confidence isaccompanied by deteriorating performance,there is no way to interpret requirements asloosely as it happened with Belgium, a countrywith significant savings and one of the relative-ly largest investment markets in the world.What is more, Southern European countrieswhich enjoyed a high level of tolerance (due topolitical reasons) regarding their compliancewith EMU requirements failed to justify thisadvanced confidence with their actual perform-ance. Therefore, citing them as examples forself-justification which is now an everyday phe-nomenon is by all means an invalid argumentboth in terms of economic theory and in eco-nomic policy.

The real priority

What was the actual economic policy priority ofthe new member states then? These countriesseemed to be in good shape for long (although

not in a sustainable manner), especially inrespect of the public finance and inflation indi-cators which Mediterranean countries strug-gled with. Interest rate convergence was takingplace and, except in Romania, the exchange ratewas fixed, i.e. it was stricter than the ERM-2. Itseems that prosperity smoothing, i.e. the inten-tional dampening of business cycle fluctua-tions, a topic discussed towards the end ofmacroeconomic policy textbooks was notamong their tools. As we could see, govern-ments in these countries did not use even themost obvious means of braking. In each coun-try concerned, deceleration happened out ofthe blue and with compelling force, as therespective governments failed to use the goodyears to lay the foundation for future develop-ment.

In many ways, the actually followed priori-ties resemble the approach of the Bush admin-istration: to respond to a complex set of chal-lenges (which relates to development econom-ics, institution establishment and Europeanintegration) with a plain, nearly simple-mindedanswer taken from elementary macroeconomictextbooks. Keep taxes low to accelerate econom-ic growth.

Naturally, these two criteria are not indiffer-ent for any economic policy. Obviously sus-tainable economic growth (Erdõs, 2003) alsomeans that economic policymakers should gofor the highest of achievable developmentcurves, provided they have an option. Similarly,the overly mature European welfare model firstled to a significant, 15 plus percentage point cutin public spending in the 80's and 90's just inthe Scandinavian countries which wished topreserve that model. However, the assumptionthat the role of governments should not gobeyond that limit proved to be a serious simpli-fication. For long term development effortsshould not target the maximum achievable levelat any point of time, but the best and lastinglysustainable level. I.e. the goal is quality growth


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that preserves the balance of the environment,society and finances. Yet it is strikingly appar-ent that these requirements were not observedin the two reviewed sets of countries. This way,their “model country” status is rather relative.It is so even though Hungary's performance interms of development does not supply reasonsfor being complacent.

THE ELEMENTS AND CONSEQUENCESOF THE NEW KIND OF POPULISM

The term populism comes from the Latin pop-ulus (people) and refers to the unconditionaland immediate serving of the popular taste.Evidently, the term originates in cultural life.Due to its specific choice of values, high cul-ture has become increasingly separated frommass culture (i.e. Vegas shows, blockbustermovies, musicals, pop music, etc.). In litera-ture, it is usually not disputed that a cheappaperback crime story and a Shakespeare dramaare two different things.

Similarly, an obvious contradiction evolvedin public life between the quality of direct popu-lar demand that is based on media democracyand mass consumption and the requirements ofthe open society and economy which call forcommunity decisions in all areas of life andexclude by nature the rule of technocrats. Thelatter requires choices between values (ineverything from educational policy to theextent of solidarity, regarding issues like e.g.family or no family, fulfilment of individual orcommunity needs) and calls for control overthe applied strategies. By nature, it requires asolid scientific base and social dialogue. Due toboth professional considerations and the roleof values, the open society and economy can-not follow actual popular demand reflected inpoll results or any other mood indicators. Inother words, it is wrong to identify democracy(a political system that is based on the people's

rule) with a government style that is actuallynothing but unprincipled drifting (or morespecifically, non-governing).13

In social sciences, populism refers to a prac-tice where decision makers exclusively followshort term popularity considerations and pay lit-tle attention (if any at all) to long-term objec-tives and values which economy and other sci-ences routinely assume as obvious considera-tions for policymakers. While the theory ofpublic choices gained significant ground, theconcept of public welfare14 must remain valid inmost analytic frameworks from mainstream toinstitutional economics, along with theassumption that governments are committedto foster public welfare. For without thisassumption, the features of direct democracyremain the last resort which proved to be unvi-able in most countries of the world.

Due to the scientific aspects involved, ineconomic theory we must generally assume thatthe government strives for collecting reliableinformation at any given time, then sort thatinformation and in most cases make decisionsalong its values and programme after an opendiscussion, all in order to serve the lastingly sus-tainable development of the country. Naturally,this is a strongly theoretical approach whichcountries have complied with to very differentextents. Still it is not futile to openly declarethe criteria of our analyses even if political talkon economic policy has become rather irrele-vant as it involves the elements of infotainmenton a nearly mandatory basis. Even some politi-cally exposed persons who otherwise seem tobe in possession of their judgement keep prop-agating that it is “natural” that actual pollresults are given preference over long-term orprofessional considerations, be it about ademographic or environmental issue, govern-ment debt or the taxation system. In the lattercase, the concept of populism would be a self-contradiction, but in science it is not – as wecould just see.


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By the 2000's, partly as a result of analysescarried out by the World Bank, the concept ofgood governance became the standard in eco-nomic theory. Besides the commonly acceptedequilibrium and growth considerations, thedesirable practice in this approach is based on awide range of human progression criteria, onthe lack of corruption and the participation ofcitizens (including the poor). We do not feelcompelled to detail this well known concepthere. We only repeatedly refer to the fact thataccording to technical literature, the involve-ment of qualitative and sustainability criteria,freedom and values into governance, even at theexpense of short-term quantitative growth, isneither new nor needs an explanation. Belowwe review some of the factors which may haveplayed a role in the economic derailment of thetwo groups of countries under review.

The reasons of economic derailment

REDUCTION OF PUBLIC BURDENS It is generallyapparent that the reduction of public burdenswas offered as a solution to all economic orsocial challenges. This author argued in manyforums in support of the viewpoint that in tra-ditional, pre-reform European welfare states,especially in the continental and Scandinavianvariants thereof, the excessive expansion of thegovernment was tangible. Regarding transfor-mation, a more general congruity may apply(Tanzi, 2005) highlighting the law that the larg-er the state, the greater the rent seeking opportu-nities are. In this context, the extent of the“ideal” state is set at the expenditure range of30–35 per cent of the GDP. Obviously this fig-ure is for orientation only and should not beregarded as a theoretical benchmark or as anevergreen target. At the same time, there is nodoubt that the Baltic countries already went forthese targets in the 90's and the Balkan coun-tries in the 2000's.

On the one hand it is apparent that this turnenabled the countries involved to keep theireconomic growth at a high level over a relativelylong period of time (for a decade or more)which is good in itself. The question is whetherthis approach is sufficient, sustainable and if itlays the right foundation for the future.Remember that in terms of per capita nationalincome, Estonia was at 68.3 per cent of the EU-27's average in 2006 (the last year for which wehave reliable benchmark figures). The corre-sponding figures in Latvia and Lithuania were54.6 and 52.1 per cent respectively, trailed byBulgaria's 36.7 and per cent and Romania's 38.8per cent. In other words, these countries arequite far from enjoying satisfactory growth iftheir growth rate dropped to the EU average of3.1 and 2.9 per cent in 2006–2007.15 The role ofthe currency council also raises concerns, espe-cially regarding long term benefits. For thecouncil did not only take away exchange rateand interest rate policy tools from the govern-ment. It also made the establishment of a finan-cial regulatory framework seen as negligible. Ifthese countries could have joined the EMU rel-atively soon in 2005–2006 as planned (forBaltic countries), it would have enabled thecomprehensive importing of regulations. Thusit seemed there is a shortcut in the long andbumpy road. After the turns described above,however, apparent advantages turned out to beactual drawbacks.

THE POLICY OF NON-INTERFERENCE Basicmacroeconomic textbooks by nature suggestthe policy of non-interference – even the betterbooks do so which otherwise declare that thecombination of external profitability, marketfailures, coordination problems and interest-seeking groups may justify government interfer-ence (which is of course far from activism, i.e.the traditional Central-European and Frenchpublic administration approach).

The group of countries discussed herein


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seemed to have neglected the fact that it is nec-essary to smoothen prosperity (and not onlyconsumption) time to time to safeguard sus-tainable growth. In a good case, governmentsshould play a helping role in this, if not an activeone. More specifically, revitalizing measures areneeded during recession and cooling measuresare needed during the periods of economicoverheating for the sake of financial and socialsustainability and to avoid extreme highs andlows that are well known for causing welfarelosses. This is the aspect from which the cor-rect setting of the growth potential may beimportant despite all underlying uncertainties(Antal, 2004; Erdõs, 2006). Of course, it stillremains to be answered whether this approach(which neglects institutional factors right fromthe start) is suitable for identifying the cause ofa country's growth performance or the lackthereof: to tell whether it came from a series ofone-off economic policy mistakes or from insti-tutional factors, i.e. the lack of reforms.16

These complex interworkings are detailedand supported with extensive literature in thereferenced writings and they can also be trans-lated into the language of economics. What ismore, they can serve as guiding points(although not accurate ones) concerning therealistically expectable rate of growth. If weconsider the fact that both of the two quotedbooks set the growth potential of theHungarian economy at or slightly below 3 percent17 (albeit along different logics), then it ishardly realistic to put the trend value ofEstonia and Slovakia (countries in the sameleague as Hungary) in the 10 per cent range. Ifwe also consider that the balance of paymentsdeficit in Estonia already equalled 15.5 per centof the GDP in 2006, 17.4 per cent in 2007 and13.9 per cent in 200818 , it is obvious that therewould have been solid reasons for hitting thebrakes. As we could see in the statistics ofother countries, it only happened late andunder pressure in each country.

The way how revenues from prosperity arespent also makes a difference. They can bespent on environmental, education or infra-structure development projects that lay thebasis for future prosperity (although they are notproducing any immediate benefits in populari-ty or for interest groups). Or economic policy-makers may only remember the beginning andthe highlighted sections of textbooks andexpect market mechanisms to do all that. Signslike regular criticism of Balkan countries by theEU (about judiciary reform), the imperfectcondition of the environment and the physicalinfrastructure in the Baltic states and slowexports in both regions (especially in R&Dintense fields) all show that the “things willsort themselves out” attitude was perhaps tootempting.

FISCAL POLICY WITH A LIMITED SCOPE What wecould see in this respect is that fiscal policyseemed to have been limited to safeguardingthe budgetary equilibrium. Naturally, this it isan important role and an enviable one forHungary. Still, there is no doubt that a tax raiseis an effective way of cooling down the econo-my, especially if a part of the resulting revenuesis spent on “unproductive”, partially govern-ment-funded or subsidised development proj-ects which could lay the foundation for sus-tainable future growth. A well-known exampleis supplied by the Scandinavian countries whereR&D and institutional development projects,lifelong learning programmes all contributesignificantly to the global competitiveness ofthese economies. It seems that governments inthe two groups of countries stayed away fromassuming this role, although it would not nec-essarily have been an anti-market move. Withthis, they actually failed to utilise the opportu-nities supplied by the good years which will bea direct cause of lastingly slower and lower qual-ity development in future years.

It is worth pointing out that regional differ-


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ences are quite significant even in the tinyBaltic countries. What is more, they evenincreased due to the concentration of capitalexpenditure to the capital cities. EU supportand cohesion funds on their own are unable tooffset this phenomenon, since their magnitudeis rather limited and the administrationalcapacity of new member states is poor.

LACK OF MODERN REGULATORY FRAMEWORK Itis clearly visible that despite the negative expe-riences of the mid-90's, little progress wasmade in the two groups of countries in estab-lishing a badly needed modern regulatory frame-work, in particular for the finance sector. If agovernment, due to any consideration, bindsitself either by relying on a currency council orselling the country's bank sector to foreigners(which is a positive move from another aspect),it will be left without economic policy tools andwill have to watch the country's economy drift-ing away in a storm fuelled by internationaldevelopments.

Proving certain mainstream financial analy-ses (Komáromi, 2008) wrong, it is not com-pletely surprising that changes in the monetarybase, especially through the lending channel,seems to have a powerful impact on long-termprice increases. In our case it means that a fixedexchange rate is only a temporary tool for bor-rowing credibility and stability. Furthermore, ithas been proved again that the size of the mon-etary base is not indifferent even on the medi-um run (this is also a decisive consideration inthe ECB's operation). Therefore, regardinglong term developments, the monitoring of themonetary base and the assessment of overalleconomic prosperity are irreplaceable tools ofany effective monetary policy. While this find-ing comes from the practices of the two insti-tutions with the best anti-inflationary trackrecord, the Swiss central bank and theBundesbank, adherence to “fashionable” inter-national trends proved to be temporarily suc-

cessful in the reviewed countries. Anotherexciting question is the extent of credibility lossafter the derailment in 2007–2008, i.e. if it isbased on anticipations or if market players con-sider it temporary only. But even in the lattercase, the vulnerability which derives from miss-ing EMU membership is still there.

LONG LEAD-TIME STRUCTURAL WERE NOT

STARTED Last but absolutely not least it is clear-ly visible that the governments of the reviewedcountries failed to use the years of high eco-nomic growth and enthusiasm over EU acces-sion to launch long lead-time structural reforms.On the one hand, it is understandable asreforms are not popular. On the other hand, weknow from the political economics of reformsthat years of prosperity are (or would havebeen) the right time for offsetting losses andcompensating the most disadvantaged groupsof society. Evidently, the social and economiccosts of ordinary (sub-optimal) reformsenforced by a severe crisis later can only behigher.19 As long as structural reforms do nothappen, only the superficial and temporarysources of growth are there, for it is well knownthat a lower level of development only providesa chance for convergence but absolutely doesnot lay the basis for it on its own. With a viewto the examples from Southern Italy to EasternGermany, convergence may indeed get stuck wellbefore a region could achieve the benchmarkaverage (a country-specific or EU figure).Taking into consideration the poor structuraland qualitative indicators of the two groups ofcountries under review, this risk is definitelythere, possibly even on a ten-year outlook.

EXPLANATIONS OF DERAILMENT

As an analyst who has been observing theregion for decades, I have to admit I do nothave a clear-cut answer to these mistakes which


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I mostly consider avoidable. In conjunctionwith the countries concerned, the key elementsof the diagnosis and the possible therapy havebeen known and discussed in economic litera-ture. Therefore, below we provide hypotheticalexplanations which do not necessarily excludeeach other and only reveal a part of the reasonsof economic derailment.

The usually cited criteria of a sustainableeconomic policy include a strong govern-

ing party and a public agreement across partieson the key objectives and values. This wasstrikingly not the case in any of the transform-ing countries. Large parties that managed thechange of the political system fell apart and thepolitical landscape changed several times ineach country. In most cases, no lasting agree-ment has been reached, especially about thedirection to follow within the EuropeanUnion. Even where the incumbent post-com-munist parties (which are relatively durable)returned to government, like in the Balkanstates and Lithuania, they function as a broadcoalition divided over a number of issues, justlike the local right-wing parties that reshapethemselves time to time. Latvia, however, ischaracterised by the presence of many politicalparties.20 The common belief of political sci-ence that the two-party system is a guarantee ofstability seems to be wrong, as the divisionsalong values and interests (and traditionallyalong regional, generational and educationaldemarks) within a party may lead to initiativesthat mutually offset each other which is a kindof drifting within the same single party. If noconsensus is reached within the elite and pro-fessionals (or if formerly made agreements fallapart), the government will not be able toimplement long-term reforms, no matter howharshly it propagates reform ideologies.

In the 2000's, redistribution ideology gainedground in all the transforming countries,

including the ones discussed herein. This ideol-ogy stems from the low acceptance of the new

power and wealth distribution model whichevolved through privatisation and democraticcompetition. Legitimacy does not simply meanthe right of the winner. What it means is thateven those who did not win accept the outcomeof the race as fair and binding for them, too. Inmost observed countries, however, this is notthe case at all and therefore contesting partiesharshly cite unrealistic “justice” concepts tomobilise the most active voters. As in the Balticcountries most pensioners are of Russian eth-nicity and thus have no citizenship, vote buy-ing which is typical in the Visegrad countries isnot present there.

At the same time, there is wide room for cor-rective action, be it about agriculture, compen-sation of original owners, various segments ofthe middle class or underdeveloped regions in aspecific country. Presumably a shift of focus inpublic debates from GDP growth to redistrib-ution would already undermine any economicpolicy consensus (which is still there amongEuro-area countries). At the same time, budg-etary reform and the scaling of expenditures inthese countries do not follow strict rules whichinstitutions could then comply with.

The deferred consumption of former yearsbroke through with elementary force

Following the ultimate failure of plannedeconomies in the 80's and the transformation-related setback after 1991, governments in bothgroups of countries believed that deliveringtangible economic growth is indispensable bothin terms of legitimacy and the image govern-ment performance. Compared to this view thegeneral economic considerations outlined inthe previous chapter may have seemed like paleand dry textbook wisdom. What is more, thevast majority of local analysts disputed theconcerns of international investors, partlybecause of hopes for the quick adoption of theEuro which was believed to resolve all issues.Indeed, if the long-term strategic approach thatused to characterise the EU before eastward

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expansion had been applied, the insignificanteconomic weight and quick growth of Balticcountries could have made them model statesfor the EU (and last but not least for formerUSSR members like the Ukraine and theCaucasus region). It could probably be a sub-ject for another analysis to reveal why this turnoccurred within the EU, striking the Balticcountries and preventing the repetition of theGreek, Portuguese and Italian example.

Since economic growth in both groups ofcountries was accompanied by the simulta-

neous improvement of the budgetary equilibri-um (what is more, by surpluses in the Balticcountries and Bulgaria), institutional reformsseemed deferrable just like caring for long-termissues like the pension system, environmentprotection, R+D, education and the forward-looking development thereof. As the EU is notauthorised to interfere with how member statesmanage these issues, national governmentswere in a position to reject the points raised bythe EU Commission and by experts, sayingthat the EU has no competence regarding thesematters. As setback after transformation wassignificant in both groups of countries, eco-nomic growth became a value on its own inthese latecomer states more than anywhere elseand was considered a valid justification fornearly anything. Then the rainy days camemuch sooner than expected.

A FEW CONCLUSIONS

Finally, we draw some preliminary but generalconclusions that may be valid beyond thereviewed years and regions. Obviously, theirsignificance can only be assessed in hindsightafter a longer period of time. Perhaps the mostimportant finding is it is futile to seek simpleanswers to complex questions, no matter howhard the electronic media is pushing analystsand public officials for such answers. The other

finding is that it is usually not worth postpon-ing painful decisions because pain only growsand never decreases over time. Good years arethe right time for launching painful steps andfor compensating the losers of change, whiletaking action under external pressure is morecostly – and of course more likely.

The deferral of the development of institu-tions is not an innocent move. Institutions man-ifest the rules of the game and thus shape thebehaviour of millions of players in the econo-my. If they are outdated, it will first make thestructure of the economy outdated which willbe followed by insufficient revenues (in partic-ular in exports), then become apparent in alower growth rate and the resulting lasting decel-eration. The one-off, game-changer opportuni-ty for convergence which EU accession provid-ed remained unutilised.

Budget and growth cannot be made inde-pendent of each other. While it is true that sus-tainable growth calls for the sustainable equi-librium of public finances, the story is far fromending there. The reasons and “quality” of theequilibrium and even the surplus do matter, asit was so extensively revealed in technical liter-ature on the operation and transformation ofthe Stability and Growth Pact. In our case, thelesson is that while a regular surplus is definite-ly more advantageous than a deficit, it can alsobecome excessive. While overheating is alwayswrong, it is quasi obligatory to spend theresulting surplus on establishing the fundamen-tal prerequisites of sustainable growth, or atleast this approach should be part of any soundgovernance and long-term strategy. Therefore,the governments in the years concerned at bestfailed to utilise the good opportunities. It is amistake that will take a significant distributionconflict to fix later.

The dangers of economic activism havebeen discussed extensively in economic litera-ture and we have argued against it in variouswritings, too. The group of countries reviewed

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herein seemed puzzling for us because it servedas a control group for the issue. I.e. they sup-plied examples of situations where the sourceof problems is not the eager beaver syndromeso typical in continental Europe, but the lack ofaction. This was obviously apparent in the fail-ure to establish a modern regulatory frame-work and in neglecting important long-termactions.

The countries in our analyses showed nosigns of traditional, Latin-American style pop-ulism at all. They were characterised by a highgrowth rate, a decreasing role of governmentand budget surpluses. Still, a different kind ofpopulism evolved there. It stemmed from themedia-friendly simplification of complex issuesin economic governance which led to theneglecting of the intellectually challenging,complicated responsibilities of economic strat-egy making. At the same time, in a growth the-

ory context that encompasses developmentover decades, the less apparent, not immediateconsequences of this practice are just as harm-ful and damaging for long-term convergenceand for the lasting competitiveness of societiesas old-fashioned populism is present in a num-ber of EU countries, including Hungary.Therefore, it is high time to push back viewsthat misinterpret democracy for no economycan successfully pursue sustainable conver-gence purely on a technocratic basis and with-out community decisions. What is more, wecannot even fulfil the current requirements ofthe EU. Through the channel of permanentexchange rate risk and higher interest rates, thisfailure will set the growth potential and actualgrowth rate of all member states outside theEuro-area below the achievable level. Decisionmakers, analysts and intellectuals are equallyresponsible for recognising this.

1 This article is based on a presentation at a conferencehosted by the Economics Faculty of the University ofDebrecen and the Chamber of Industry andCommerce of Hajdú-Bihar County held in Debrecen,Hungary on 28 March, 2008. Selected presentationswill be published in a book edited by László Muraközyat Akadémiai Kiadó publishing house.

2 Obviously this applies to the balance of paymentsand not the balance of trade. Many countries wherethe weight of invisible items is significant can livewith deficits larger than this on the long run, too.Examples include countries from Austria throughCroatia to Greece, as the tourism industry, commer-cial shipping and financial services may even play adecisive role in post-industrial societies but they aredefinitely more significant than traditional trade andproduction. This is not the case in any of the coun-tries in the text above.

3 Countries that belong here include Venezuela,Bolivia, Nigeria, Malaysia and Russia.

4 Rimsics, I. .(2008): Recent economic developmentsand banking in Latvia (notes). Riga, June, availableat: www.bank.lv./eng, downloaded 2 July 2008.

5 Macroeconomic development and outlook for theLithuanian economy, 30 April, elérhetõ: www.lb.lt/eng, downloaded on 3 July 2008

6 Bank of Estonia: Estonian Economic and MonetaryPolicy, no. 1/2008, page 19, accessible at www.eesti-pank.info, downloaded on 3 July downloaded on 3July 2008

7 ECB: Statistics Pocket Book, May, 2008, Frank-furt/M., pp. 37, 38, 44

8 Bulgarian National Bank: Economic Review, no.1/2008 available at www.bnb.bg,, downloaded 3 July2008.

9 National Bank of Romania/2008/: Inflation Report,May, page 39, available at www.bnro.ro/publications,downloaded 3 July 2008

10 UniCredit Group (2008): CEE Quarterly, no. 2.Vienna (a quarterly publication with statistics andanalyses), page 28

11 What may have played a role in this is that foreignownership of banks is far less common in key EU

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countries as in the new member states and inCroatia.

12 Every government weighs a number of factors atany given time. But it is not the same as declaringsome hard and fast values which the governmentwill not act against but rather strive for achievingthem.

13 This is what several non-governmental organisa-tions do, among them the “Márciusi Charta” whovoice valid concerns about the moral state of thecountry.

14 The Pázmány Péter Catholic University and theKonrad Adenauer Foundation staged an interna-tional conference on this complex and controversialphilosophical issue in Budapest on 28 February2008. Selected presentations will be published in abook edited by Ferenc Berán.

15 Source: ECB: Statistics Pocket Book, June, 2008,Frankfurt/M., pp. 38–39

16 Regarding the Hungarian economy, it was GyörgySurányi (2008) who outlined in the most clear-cutmanner (in a debate with László Lengyel) the quasi-conservative view that even the lack of major

reforms would not have caused performance prob-lems in the 2000's, provided the obviously sillymoves and extremities had been omitted in eco-nomic policymaking.

17 It is another question that not even this figureshould be considered automatically achievable,thanks to the series of popularity-seeking measuresand the comprehensive loss of credibility of eco-nomic policymakers. Most analysts more or lessunanimously rejected these steps. What is more,some analyses point out that more than 1 percent-age point of the growth in 2004–2007 stemmedfrom unjustified budgetary expansion.

18 UniCredit Gruop: op.cit. page 14

19 And of course the ant's extra work will not beblamed on the cricket of whom good memories willbe cherished …

20 The four-party governing coalition is becomingfragile just now due to a series of scandals aroundthe anti-corruption agency and an initiative toenable the dissolving of parliament with a refer-endum. See Economist Intelligence Unit: Latvia-Main Report, London, 18 July 2008 (on-line edi-tion).

ANTAL, L. (2004): Is economic growth sustainable?(Fenntartható-e a fenntartható növekedés?) Budapest,Economic Review Foundation (Közgazdasági SzemleAlapítvány)

BACKÉ, P. – ÉGERT, B. – WALKO, Z. (2007): CreditGrowth in central and eastern Europe reconsidered,Vienna, ÖNB, Focus on European Integration, issue 2,www.onb.at

BORKÓ, T. (2008): Sustainability of naturalresource-rich countries with different backgrounds inthe light of international indices. (Eltérõ hátterû, nyer-sanyagban gazdag országok növekedésének fen-ntarthatósága a fõbb nemzetközi indexek fényében),Competitio/ Debrecen, volume 7, issue 1, pp. 145–168,www.econ.uideb.hu/kutatás

BÖNKER, F. (2008): Von der Europaisierung zur De-Europaisierung? Das Beispiel der Steuerpolitik inOstmitteleuropa, In: BÖNKER, F. – WIELGOHS, J. ed.:Postsozialistische Transformation und europaeische/Des/integration, Marburg, Metropolis Verlag, pp. 199–210

CSABA, L. (2007): The New Political Economy ofEmerging Europe, second, revised and extended edi-tion, Budapest, Akadémiai Kiadó publishing house

DARVAS, ZS. – SZAPÁRY, GY. (2008): Euro-areaenlargement and euro adaptation strategies (Azeuróövezet bõvítése és euróbevezetési stratégiák),Budapest, Argenta Studies (Argenta Tanulmányok),issue 1, revised version to be released in the EconomicReview (Közgazdasági Szemle)

DORNBUSCH, R. – EDWARDS, S. ed. (1991): TheMacroeconomics of Populism in Latin America,Chicago, The University of Chicago Press

ENOCH, C. – ÖTKER-ROBE, L. ed. (2007): RapidCredit Growth in Central and Eastern Europe:Endless Boom or an Early Warning? New York,Palgrave for the IMF

ERDÕS, T. (2003): Sustainable economic growth(Fenntartható gazdasági növekedés), Budapest,Akadémiai Kiadó publishing house

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ERDÕS, T. (2006): Growth potential and econom-ic policy (Növekedési potenciál és gazdaságpoliti-ka), Budapest, Akadémiai Kiadó publishing house

ÉGERT, B. – DRINE, I. – LOMMATSCH, K. – RAULT,U. (2003): The Balassa-Samuelson-effect in Centraland Eastern Europe: Myth or Reality? Journal ofComparative Economics, volume 31, issue, pp.555–572

GYÕRFFY, D. (2007): Rules and choices: fiscal poli-cy leeway in the European Union (Szabályok ésválasztások: a költségvetési politika mozgástere azEurópai Unióban), Külgazdaság journal, volume 51,issue, 11–12, pp. 60–76

KÁDÁR, B. (1977): The economic dilemmas ofLatin-America, Budapest, Közgazdasági és JogiKönyvkiadó publishing house

KOMÁROMI, A. (2008): The role of monetary aggre-gates in monetary policy (A monetáris aggregátumokszerepe a monetáris politikában), Budapest, MNBStudies, issue 71, January, www.mnb.hu

LÁMFALUSSY, A. (2008): Financial crises in devel-oping countries (Pénzügyi válságok a fejlõdõ orszá-

gokban), Budapest, Akadémiai Kiadó publishinghouse

MEHLUM, M. – MOENE, K. – TORVIK, R. (2006):Institutions and the resource curse, Economic Journal,issue 508, January 2006, pp. 1–16

MURAKÖZY, L. ed. (2007): “The surface speakswhile the depth is quiet.” The conscious and uncon-scious aspects of economic policy (“Fecseg a felszínés hallgat a mély”. Tudatok és tudatalattiak a gaz-daságpolitikában) Budapest, Akadémiai Kiadó pub-lishing house

SURÁNYI, GY. (2008): In defence of reason (A józanész védelmében), Népszabadság, 14 June

SZEGVÁRI, I. (1988): The fruitless struggle ofeconomic policy with external disequilibrium (Agazdaságpolitika eredménytelen küzdelme a kül-gazdasági egyensúlyhiánnyal) (1979–1986), partsI–II, Külgaz-daság journal, volume 32, issues 7–8and 9

TANZI, V. (2005): The economic role of the state inthe 21st century, CATO Journal, volume 25, issue 3,pp. 617–638, www.cato.org


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Gyula Nagy

Role of financial innovationsin oligopolistic market environment

Price stability usually prevails in the long run inoligopolistic markets, and the role of price race isreplaced by research & development and innova-tion, advertising, and brand names. The currentbanking market of Hungary is strongly oligopo-listic, with limited price competition in the scopeof financial products and services. Various finan-cial innovations, brands, and name brand values– as well as intensive communication thereof byadvertisements and other PR tools – are ofincreasing significance in banks' successful marketstrategies.

SPECIAL CHARACTERISTICS OF OLIGOPOLISTIC MARKET STRUCTURES

As one of the most important results of thebanking privatisation in Hungary, large foreignbanking groups have been active in theHungarian market as owners since the mid-90s,contributing to the stability of the Hungarianfinancial system, the expansion of financialintermediary services, and the efficient servic-ing of economic entities by their capitalstrength, sophisticated banking products andservices, and by developing infrastructure inbanking. All this happened in a banking envi-ronment whose structural features decidedlyreflect an oligopolistic market. In such an envi-

ronment the importance of the role of factorsthat influence success in the market (price,quality, reliability, brand value, innovation,marketing communication) shifts, adopting tothe specifics of the individual market segments.This is the explanation for an unorthodox phe-nomenon that while the Hungarian bankingmarket is oligopolistic, and in certain casesmonopolistic, with strongly homogenousproducts and services, there is strong competi-tion in certain customer and product segments,and financial innovations play an increasingrole in market share expansion.

Market structures and competition

Individual market structures prompt marketplayers to respond by adequate approach andconduct.1 Competitive strategies devised inorder to be successful in the market are typi-cally growth-oriented, because stronger mar-ket positions mean higher profits, whichrequire stronger capital base, which in turnmeans that corporate value maximisationresults in an increase in size. A polypolisticmarket structure is a competitive environmentwhere a multitude of players are present onboth the demand and the supply side, but noneof them has such a clout as to being able to


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manipulate prices. There is a strong price com-petition, all market players face the constantthreat of losing market positions, the demandis driven by prices and highly volatile. In thismarket environment all players expect pres-sures to emerge from cost and demand sidealike. In order to design a competitive pricestructure, every market player has to developtheir applied technologies, products, or thesales process itself, which means there is astrong pressure for research and development.Competitive edge secured this way may wellbe short-lived, because there is a realisticchance that it will be neutralised by similarinnovations or even imitations marketed byrivals. Therefore, one of the main motivationsfor innovation is to ensure pioneer profit, butwhen it cannot be exploited fully, a trailingstrategy will become typical.

When the above market structure is inter-preted as a competition market with players ofroughly identical strength, then a monopolisticmarket represents the other extreme. This mar-ket could also have multiple players on the sup-ply side,2 but one of them is in a power posi-tion, dictating market conditions and pricesand making all the other players adapt. Thisset-up does not rule out competition amongthe other market players, but the corporationin the monopoly position is less compelled toimplement cost cutting or to carry out researchand development, which would ensure lowercosts. Also, the corporation is directed awayfrom product innovation by the assumptionthat profits to be expected of new products willbe earned at the expense of the profit on oldproducts. Also, the return on developmentinvestments is not guaranteed, thus corpora-tions in monopoly position are unlikely to risktheir existing high market shares by thesecosts. Undoubtedly, in the short term theyshould not fear the appearance of rivals who'dmake their positions vulnerable by copyingtheir products, but fears of newcomers could

keep up their interest in research and develop-ment in the longer run.3

The market structure in between the twoextremes is called oligopoly, where the market isdominated by a relatively few players withpowerful capital bases who are too strong toimprove their market positions by price com-petition at the expense of the others. Thisstruggle could go on for too long without anysubstantial reshuffle in existing positions, notto mention its cost impacts. Since it's a fewplayers, chances are they will regulate the mar-ket by informal agreements (cartel) rather thanentering a cut-throat race to 'bleed' each other.Obviously, their options are subject to compe-tition regulations in the country, how efficient-ly competition authorities can act against com-petition-restricting practices and informal car-tel agreements. If price reduction – price com-petition in other words – is not the path to taketo improve market positions in an oligopolisticmarket environment, then the regulatory roleof prices diminish, while the impacts of otherfactors grow stronger. Similarly to the polypolis-tic competition market, the need for researchand development is also present in this marketstructure, but at a lower intensity, because nodirect relation can be ensured between R&Dcosts and the profit they generate.4

Market structure cannot be separated fromthe size of the market players, because adjust-ment to changing market conditions, as well asthe compulsion and willingness to carry outresearch and development activities are chang-ing accordingly. In analysing the connectionbetween absolute company size and innovationactivities, J. Schumpeter reached the conclu-sion that technological renewal results in muchgreater production and welfare impacts thanever achievable by improving the distributionof assets.5 Among his followers, J. Tabbert saystechnological progress depends on large corpo-rates with quasi monopoly power, and innova-tion efforts can be expected by them mostly6,


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because they are in a position to take the nec-essary costs and risks, and funding is also avail-able to them. The intensification of the consol-idation processes that create a monopoly posi-tion can also be attributed to the fact that tech-nological progress demand an increasing opti-mum corporate size due to declining yields,thus costs savings ensured by economies of scaleare basically available to large corporations. Ofcourse, only when they see the research activi-ties and their results through and manage mar-ket implementation. In this scope, however,the competitive edge of large corporation is notso unambiguous, because diseconomies of scalemay emerge as they are less inclined to imple-ment innovation-driven products in the marketas soon as they can.7

Oligopolistic banking market in Hungary

The credit institutions of the Hungarian finan-cial sector that operate as companies limited byshares are analysed below, using the prelimi-nary data for end-2007.8 Said group of institu-tions comprise 38 credit institutions in the fol-lowing breakdown: large banks (7), medium-sized banks (11), small banks (15), and spe-cialised credit institutions (5).9 The main char-acteristics of the structure of the banking mar-ket have been defined by the aggregate figuresof total assets, equity, and after-tax profit assubmitted to the PSZÁF [Hungarian FinancialSupervisory Authority].

The strongly oligopolistic nature of theHungarian banking market is underlined by ahigh level of concentration in the aggregate totalassets of the credit institutions in the analysis.Accounting for 18.4 per cent of the entireHungarian banking sector in terms of quantity,the market share of the seven universal largebanks10 amounted to 72.88 per cent at the end of2007 while the most populous group – that of

small banks – owned a mere 3.31 per cent of allassets. The combined weight of medium-sizedbanks and specialised financial institutions –14.53 per cent and 9.28 per cent, respectively –could not offset the dominance of large banks,either. The picture is further refined by the factthat OTP Bank, the largest player in theHungarian market, single-handedly accountedfor more than one-fifth of the aggregate totalassets (See Chart 1). Evident in the Hungarianretail banking market, 'the leader-follower model[…] the ensures high profitability for the market-leader bank […] while providing a profit for rivalsthat covers costly expansion.”11

As for equity, a similar image emerges. Largebanks hold a 75.58-percent share in aggregateequity, reflecting a little denser concentrationthan in terms of total assets. Smaller banks hada bigger share (5.20 per cent ) at the expense ofspecialised financial institutions (4.99 percent), and the weight of medium-sized banks(14.23 per cent) in fact did not change.

According to preliminary data, the 38 creditinstitutions reported HUF 316.5 billion inafter-tax profit. Large banks accounted for82.76 per cent, medium-sized banks and spe-cialised credit institutions were responsible for13.40 per cent and 4.67 per cent, respectively.The combined after-tax profit of the fifteensmall banks, however, reflected a loss of morethan HUF 2.6 billion.

According to the report of the VárhegyiCommittee 'an empiric analysis of the Hungarianbanking market indicates decidedly weak pricecompetition in certain segments of the retail bank-ing market (overdraft, consumer credits, personalloans, current accounts)'.12 A limited role of pricecompetition is one of the typical characteristicsof an oligopolistic market structure. Limitedprice competition prevents significant discrepan-cies not only in the prices of “mass products”(such as account packages) but in the terms ofconditions of deposit and loan products thatcould influence customers' choice of banks.


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Banks should implement adequately transparentpricing and comparable contract conditions toallow these minute differences detected, whichcould at the end of the day provide basis for cus-tomers to find the best-suited tailor-made finan-cial solutions. This, however, would require morecomprehensive information on the content ofbanking services, the cost impacts of each service(comparability of interest rates and fees), andrights of obligations of banks and customers.

FINANCIAL INNOVATIONS

In this section the ways financial innovationscould replace or supplement price competition,which is relegated to the backseat by the oli-gopolistic market, are scrutinised. These arefinancial products and instruments that havewidened the horizon for investors thinking inyield/risk terms by making them believe: high-er risks do not necessarily come with a propor-tionate increase in risks, because risks can be

spread in globalise financial markets owing toincreasingly complex financial products. Theirexpansion and increasing popularity were feed-ing on two sources. One stemmed from thebanking system, which expected financial inno-vation to provide remedy for declining prof-itability. Investors had a keen interest in newinstruments, primarily because of high yieldsand their seemingly low (underestimated) risks.This latter illusion was further intensified bythe fact that inadequately transparent financialinstitutions devised “rebundled” products –which were innovative but high-gearing designsthus containing exponential inherent risks –creating markets where appropriate control andregulations have yet to be implemented.

Financial innovations – risk correlations

The scope of financial innovations is quitewide, the most general description being a poolof novelty investment and financing instru-

Chart 1

SHARES OF FINANCIAL INSTITUTION GROUPS(per cent)

Source: author's own calculations

Total assets Equity After-tax profit

Large banksMedium-sized banks

Small banksSpecialised credit institutions

In percentage, based on 31 December 2007 preliminary data

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ments that have yet to be made available inlending, equity and financial markets.13 In thefinancial regulations of Germany, financialinnovation refers to securities that transformtaxed interest income into tax-free capital gainstax.14 Financial innovations represent newfinancial instruments, market practices, andsales techniques that promote the acquisitionof new customers, the reduction of fundingcosts, and the chance for additional liquidity byincreasing funding. Financial innovation prod-ucts facilitate speculation-driven income basedon high risks inherent in interest and exchangerate volatility and capital gearing, at the sametime the spreading of risks, and the avoidanceof certain administrative regulations of finan-cial markets. Financial innovations are closelylinked to the progress in information and com-munication technology, which, mainly startingin the 80s, triggered a surge in the size of glob-al financial markets.

Financial innovations include the typicalproducts of securitisation (euro securities, vari-able-rate securities, depository receipts, zero-coupon bonds). Carry trade transactions,derivatives (futures, swaps, options), and inno-vative financial institutions with extremedynamism such as hedge funds are also includedin this scope. The majority of the latter are heldby investors that have positions financed bycarry trade, and when they close these posi-tions on a mass scale it could trigger chain-reaction-like disruptions even on markets thatare geographically far from one another. Thepossibility of a fast-paced infection on globalmarkets raises a number of issues for mone-tary authorities in respect of regulation andcontrol, as also mentioned by FED governorBen S. Bernanke,15 because financial innova-tions carry considerable risks and spreadingthem around in global economy while servingge-neral economic objectives such as financialstability, investor protection, and market inte-gration. The current financial regulations,

however, have no efficient regulations to man-age the downsides of these designs.

Mentioned among financial innovations,securitisation – used by multinational commer-cial banks more and more extensively thesedays – means a design where banks sell assetsthey've disbursed (mostly mortgages and syn-dicate euro loans) in the form of bonds in themarket, thus banking loans are “rebundled”into securities. For banks it means they getback their loans which they can disburse again.These loans are then delisted from their balancesheets and transferred to a special financialservice provider (SPV),16 which starts market-ing securities and bonds using these securitisedloans as collateral. This relatively simple oppor-tunity to get rid of risks, however, represents astrong urge for banks to ease their strict loanassessment procedures, because the risks oflending should not be borne by them and nofinancial responsibility links them with the spe-cial purpose vehicle.

Higher risks represented by financial inno-vation products manifest themselves in thescope of derivative products in such a way thatthe value of these products are subject to themarket prices of one or more underlying prod-ucts, and a future obligation for buying or sell-ing is attached to them. Any profits or lossesmade in a derivate deal are subject to the dif-ference between the contractual and the actualprice, and – due to unforeseeable price volatili-ty – they come with much higher risks thanusually seen in stock markets. The explanationis that investors buy shares in traditional stockmarkets in hopes of higher yields representedby dividends and higher share price gains.Experience indicates that investors that makelong-tem stock investments prove successful,because they have time to wait for share pricesto climb. However, when an investor invests infinancial innovation instead of buying shares,for instance by buying a futures contract forthree or six months and expecting the share


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price to increase, then the time factor as wellas stock market trends shall be taken into con-sideration. If the expected price increase hap-pens just one day after the futures deal hasmatured, then the investor has to kiss hismoney good-bye.

Investors have to live with market risks, andfinancial innovations can't change that, either.German daily Die Zeit17 brought up the law ofconservation of energy in thermodynamics,which postulates that energy does not decreasein a closed environment, as the analogy for theassumption that no financial innovations, nomatter how efficient they are, can reduce mar-ket risks. All these designs manage is a differ-ent spread of risks. In this light, it's no coinci-dence that experts from the German financialregulator underlined in respect of the U.S. sub-prime mortgage crisis that data released so farwere completely contradictory to the thesisthat financial innovations by themselves triggerconsiderable welfare impacts by spreading riskswider.18 Due to high capital gearing, detectingand managing the actual extent of risks deliversa more complex task for financial risk manage-ment than in other, more traditional, businessscopes. Sándor Czirják establishes that 'thereare huge income and amounts invested in mutu-al funds that cannot be justified by real economyterms […] and central banks cannot do muchabout them'.19

INNOVATIVE DESIGNS IN THE HUNGARIANBANKING MARKET

The demand for applying financial innovationin the Hungarian market has been growing,banks come up with products that carry higherand higher risks in an attempt to compensatefor their stagnating or declining ROE andROA (Return On Equity and Return OnAssets, respectively). Financial innovations inthe scope of deposits and investments in the

retail market, one of the most important fund-ing sources for banks, are scrutinised below.Neither the corporate nor the municipal mar-ket is analysed here. New financial instrumentsdeployed by financial institutions in the retailmarket in the race for savings cannot always beconsidered innovations, because most of themare just creatively composed, 'repackaged'instruments. Nevertheless, they reflect well thechange in concept as banks are trying to adaptto changing customer demand by devising newproducts and services.

Combinations of fixed deposits andequity market investments

The phenomenon that traditional depositproducts offered by banks are losing their yieldappeal due to increasing inflation has beenapparent lately. In order to improve the realyields of their savings, however, customershave increased their demand for investmentopportunities that offer higher yields and rea-sonable risks. The increase in the in the globalrisk propensity of investors has promptedHungarian banks to react fast and offer theircustomers a wide variety of stock investments,or combine their traditional deposit productswith high-yield stock investments. These com-bines investment portfolios are registeredunder different names at some of the banks,but their structures in terms of yields and risksare very similar (See Chart 2).

Customer savings of higher yield expecta-tions are managed by banks as a portfolio partof which is invested as deposits and the otherpart is invested in the investment notes of var-ious mutual funds (mostly open-end funds),representing a basket of various yield and risklevels. The proportions at which the portfoliois divided are typically defined by the individualbanks. In these designs, the deposit part iscompletely risk-free as far as capital repayment


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is concerned, and an outstandingly high fixedrate is due for the first 2 or 3 months, makingthe yields of this half of the design predictablewith high accuracy. Following the maturity ofinterim period, the deposit part of the portfo-lio continues to earn a risk-free yield, but nowonly at the (lower) rate defined by the list ofconditions effective at the moment.

The other part of the portfolio is invested inrisky stock market instruments, investmentnotes of open-end funds, and fund of fundsdesigns20 that have stock indices of the mostdynamic markets and some commoditiesindices as underlying products. These designscome with special methods to calculate yieldand special payment schemes. Investment fundmanagement companies owned by banks actu-ally channel savings invested in their invest-ment notes back to their banks as deposits,which could be very important for the banksfrom the aspect of liquidity management.21

In order to make them acceptable for cus-tomers, banks try to reduce the higher risks of

stock investments by various methods. Appliedin a wide scope, capital-guarantee designs22

means the bank guarantees repayment of theinvested capital, thus the potential loss to beincurred to the investor in the worst caseaffects the yield but not the principal. Alsoaimed at increasing customers' propensity toinvest, banks would also pledge guarantee on aminimum yield in a design named yield-guaran-tee investment.23 Practically, it means therepayment of the invested principal plus a pre-defined yield following a certain maturity.

Homogenous range of products and services

In the deposit segment of the Hungarian bank-ing market, quite an intensive competition isevident among credit institutions – somewhatdeviating from the general situation. While theschemes described above – namely the combi-nation of deposits and stock investments in

Chart 2

PROFITABILITY INDICATORS OF THE HUNGARIAN BANKING SECTOR

Source: MNB Jelentés a pénzügyi stabilitásról [NBH Report on Financial Stability] (April 2008) ttp://www.mnb.hu/Engine.aspx?page=mnbhu_sta-bil&ContentID=10897

ROE (left scale) Real ROE (left scale) ROE (left scale)

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some design – can hardly be called classic finan-cial innovations, they are to be regarded as newfinancial instruments, because they facilitatehigher yield demands to be met and risksspread reasonably.

These financial schemes, however, are unableto ensure a permanent competitive edge,because these products of banks sooner or laterbecome homogenous on the back of imitationand their conditions will also be very similar.The success of individual banks in accumulat-ing funds from the market – and thus expandtheir marker share and increase their customerbase – is closely related to the size of the nom-inal interest rate they are offering, because cus-tomers intent on savings in deposit designs willbasically select banks by their motivation toachieve higher yields. This means product pric-ing is a top priority in this scope, indicatingthat there could be some segments in an oli-gopolistic market environment that act as ifthey were part of a polypolistic market struc-ture. This in turn means price competition isthe decisive factor, demoting the other factorsof bank selection (brand value, reliability, qual-ity of service, access etc.). A very intense pricecompetition has evolved in the Hungarianretail banking market, keeping available mar-gins low and thus damaging the profitability ofbanks. (See Chart 3)

The period preceding the implementation ofthe interest tax in September 2006, when a veryaggressive competition developed among banksto win customers, delivered a remarkable expe-rience regarding business policy and communi-cation alike. Although they managed tomobilise billions of forints of savings by mar-keting deposit designs that offered relief fromthe interest tax, their margins had decreaseddue to competition, the net interest marginbarely exceeded one or 1.5 per cent. The samephenomenon was evident one year later in therace for securing maturing deposits. The graphreflects well the fact that the banking spread

was declining from March 2006 untilDecember 2007 constantly, dropping by morethan half a percentage point. This trend contin-ues in the first quarter of this year.

Interestingly, it was not the largest retail bank,OTP, that emerged victorious in the race for theacquisition of customers and funds. In their sub-sequent external communication, the manage-ment of the bank emphasised not the failure ofthe bank to respond to this one-off retaildemand with appropriate speed and flexibility,but the bank's decision of refusing to pay any-thing for customer acquisition. For so attractiveconditions should have been offered by the bankto lure this price-driven and therefore swayingcustomer scope, which is very hard to hold onto, that the management of OTP rejected afterconsidering profitability aspects.

This story has several interpretations fromcommunications aspects. One, OTP woke uplate, had been overtaken by rivals, and couldnot exploit this opportunity. The other expla-nations says the bank regarded the retention ofits existing customer base as having a highervalue than acquiring a price-oriented, barelypredictable scope of new deposit holders.

General experience indicates that when abank's customer policy sets expansion objec-tives for the purpose of raising funds, it shouldbe supported by the bank's communication,emphasising interest conditions that are betterthan the rivals'. This product communicationwill mostly acquire customers for whom priceis the only or a top priority aspect. In thesecases components of the brand and corporateimage have limited use, because they have hard-ly any impact as their messages barely registerin the decision-making process. The measura-ble success of communication (increase in cus-tomer number, raising funds) is subject not tothe communication activity itself but to anexternal factor, the price of the product inquestion. The consequence is not free of a cer-tain trade-off impact: The increase in funds


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could happen as a result of a dilution in the cus-tomer base by an unstable group of depositholders.

The objective of establishing a permanentand reliable customer base in a strongly seg-mented customer policy can be supported suc-cessfully by targeted communication that facil-itates for the bank to linking of products andservices on both the assets and the liabilitiesside and to employ cross-selling. Here, com-munication plays not just a monotone tune butemploys an orchestra to play specific chordsfor various target groups. An important lesson,a market player should not shy away fromcompeting aggressively in customer segmentsthat promise high margins.

LEVELS OF INNOVATION

For the sake of successful operation in a com-petitive environment, innovation has become afactor with increasing significance for econom-ic entities, including those in the financial

scope, banks in particular. In addition to organ-ic growth, and mergers that cause fast-pacedincrease in size, innovative financial designs,the implementation of new products and serv-ices can ensure expansion in the market.According to a study made by IBM Institutefor Business Value,24 innovation allows a com-pany to distinguish itself from the competitors,to lift it up from the mass of similar companies.In other words, unorthodox financial innova-tions help a company adapt to marketdemands, contribute to an increase in profit,help create and maintain a competitive edge,and facilitate expansion in the market. (SeeTable 1)

Innovation process requires new ideas, orassumes a radically different way of thinkingthan the one typical presently. John White, headof IVB's research team, says25 innovation hasthree main types and application areas. One ofthem is innovations in products and services, ascope already mentioned here. The other com-prises operational innovation, new solutions toimprove the efficiency of the bank main opera-

3. ábra

BANKING SPREAD AND COMPONENTS

Source: National Bank of Hungary, http://www.mnb.hu/Engine.aspx?page=mnbhu_stabil&ContentID=10897

Interest cost/avg interest-bearing funds (left scale)Interest income/avg. interest-bearing assets (left scale)Spread (right scale)

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tional scopes and core activities. The third is theinnovation in business model, in the course ofwhich the bank creates a new target, restruc-tures its organisational structure, its scope ofactivities, and expands its market operations.

Product innovation means the renewal ofbanking products and services, allowing accessto new market segments and customers, at thesame time helping retain existing market posi-tions and customers. In terms of differentia-tion and distinction from competitors, howev-er, product innovation can only deliver tempo-rary successes, because new designs are rela-tively easy to copy. Having a more permanentimpact, the future is dominated by innovationsthat impact operative processes and the basisof corporate operation model, As shown inTable 1 above. This presumes a different atti-tude, because it builds on openness and coop-eration rather than the seclusion of productand services innovation, and crosses organisa-tional and institutional barriers. Applied tech-nologies and business integration are the mostsignificant factors of a marked and long-termsustainable differentiation; nevertheless themost popular innovation process focuses onthe renewal of the scope of products and serv-ices – including imitation – because banks are

driven in this direction by cost impacts andtime requirements.

Financial innovations can only be successfulwhen development processes are subordinatedto customer demands, and the establishment ofthe infrastructural background of innovationsare managed with priority. This is an environ-ment that facilitates efficient integration ofbusiness processes and technologies that servethem, in order to create banking value.

FINANCIAL INNOVATIONS IN THE HUNGARIAN BANKING MARKET

Price competition is demoted in most marketsegments in the strongly oligopolistic marketstructure of the Hungarian banking sector.Based on international experience, this circum-stance should increase the need for financialinnovations, as they play an important role inmarket expansion and profitability.

According to an NBH analysis,26 the prof-itability indicators of the Hungarian bankingsector are satisfactory in international compar-ison, but have been deteriorating continuously.ROE indicator has been declining at a largerextent than ROA, but the development of both

Table 1

CHANGING NATURE OF INNOVATION

Characteristics of current innovations Characteristics of future innovations• Emphasis on innovation in products and services • Wide scale, including innovation in bussiness

modell

• Driven by development and technology • Driven by customer demands and technology

• Pivotal role for Research & Development • Pivotal role for management and individuals, because

R&D seen as major innovation carrier

• Uncooperative; an internal affair for the company • Open and cooperative, passes organisational and

corporate barriers

• Distinction from others ensured by technology • Distinction from others by integration of technology

and business activity

Source: IBM Institute for Business Value, In:Dare to be different: Why banking innovation matters now (2007), IBM Global Business Services,page 4 http://www-935.ibm.com/services/us/index.wss/ibvstudy/gbs/a1025350?cntxt=a1000043


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indicators suggest that the competitive edge ofthe Hungarian banking sector has been deteri-orating at an accelerating rate especially com-pared to developed countries, but has becomeunfavourable in comparison to banking sectorsin the CEE region, as well. (See Chart 4).Experts of financial innovations say these fac-tors represent the necessary prerequisites ofinnovation taking place in the banking sectorboth in the scope of products and services aswell as technological processes and organisa-tional changes. However, the application andexpansion of financial innovations cannot beseparated from the general standard of financialculture, in other words the acceptance level ofthe customer segment targeted by these newfinancial instruments.

Depth indicators reflecting the operation andquality of the Hungarian system of financialintermediaries, however, attest to constant

improvement. The combined total assets of theHungarian banking sector is close to the GDP,and the banking loans of the private sectoramount to half the gross domestic product. Thefinancial system has been growing deeper despitethe slowdown of economic growth, which indi-cates that the population attempts, in spite of aus-terity measures, to maintain the consumptionstandards they have gotten used to. An upswingin the portfolio of all-purpose mortgages or theappearance of high-risk yen loans are ample proofof that. Although in the event of default thepotential losses of lending banks will be lower dueto real estate collaterals, the process providesample indication how much the household sectorrefuses to acknowledge increasing financial risks.

In order to maximise yields on savings gen-erated on decreasing real wages, a rather widescope of the population shows willingness toinvest in stock investment designs and fixed

Chart 4

ROE AND ROA INDICATORS IN INTERNATIONAL COMPARISON (2006)

Source: National Bank of Hungary, http://www.mnb.hu/Engine.aspx?page=mnbhu_stabil&ContentID=10897

ROE (After-tax profit /Tier1)ROA (After-tax profit/total assets; right scale)ROA adjusted for one-off income (2006) (right scale)


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deposits combined with stock investments,both designs being among high-risk financialinnovations. To maintain lending expansion,banks have to increase funding, thus they arekeen to meet these demands in their depositoffers, even feeding these demands by increas-ing marketing costs and using the tools ofbusiness communication. The aforementionedreport of the Hungarian central bank establish-es that 'risk-based competition among banks alsointensifies, manifesting itself in the developmentof increasingly risky products and in the easing oflending conditions.'27

Considering the fact that the ratio of interestincome compared to fee and commissionincome is outstandingly high and constantlygrowing in the Hungarian banking sector ininternational comparison, it is evident that prof-itability is thereatened from two sides. One ofthe factors is the consequences of the subprimemortgage market crisis – rising interest rates onthe back of credit crunch in particular – and theother component is the fight for deposits in theHungarian market, which increases fundingcosts. Their combined impact projects a deterio-ration in the profitability of the entireHungarian banking sector. (See Chart 5)

As banking products and services becomestrongly homogenous, banks apparently try todevise their service packages by heeding cus-tomer demands. A peculiar example of financialinnovation is application consulting, a productscope where competition is fought in offeredservices rather than prices, by which banks tryto acquire micro businesses as well as small andmedium enterprises. The service packages mar-keted by banks offer, in addition to financing,the search for applications, consulting, thepreparation of the bid itself, and the complexjob of 'after-sales care' for applications. Banksthat vie for enterprises applying for EU andHungarian economic development funds aredifferentiated by their 'prices, flexibility, collat-eral requirements, and service standards'.28

CONCLUSIONS

Designed in deference to the environment asrepresented by the market structure, competi-tion strategies use a wide variety of tools toensure that the targets of expansion, efficiency,and profitability be met. Competitive pricing ofproducts and services has an eminent role, com-plemented by innovations representing brandnew solutions (renewal of products, technicalprocesses, and the business model itself), relatedResearch & Development activities, as well asbrand values and, not the least, marketing com-munication. Price competition is dominant in apolypolistic market structure, but in an oligopo-listic market environment it loses significance,becoming less of a tool to achieve competitionpolicy goals. Consequently, other tools and com-ponents – especially innovations created byresearch and development – will see appreciation.

Amid wide-spread financial globalisation,market competition intensifies, but not neces-sarily in the form of price wars alone, manifest-ing in a fast-paced expansion of financial inno-vations that manage to meet investors' differ-entiated demands for yields and risks. On theorganisational and institutional side, consolida-tion processes intensify, to be fed further bymega mergers and acquisitions. At the sametime, an explosive progress is evident in theproduct range, resulted by the implementationof more complex products and service pack-ages, as well as creatively combined savings andloan products. These offer customer less andless transparency; and while price competitionis primarily focused on components of publiclyannounced – well-communicated – conditions,transparency is damaged, and consumer deci-sions are manipulated by marketing messagesand advertisements, and comparison betweenthe products and services of banks becomesincreasingly hard.

The appearance and fast-paced expansionof financial innovations on global financial mar-


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kets was connected to the large-scale boost inliquidity that had been based on global eco-nomic growth, central banks' expansive mone-tary policies, and growing savings at oil produc-ers on the back of surging oil prices since theearly 2000s. Exceeding real economy demandsby far, this excess liquidity was tapped by aninvestment race which increased global riskhunger. Against this backdrop, various financialinnovations (securitisation, carry trade)increased the risks of the overall global financialsystem and established the channels throughwhich local or regional market problems man-aged to spread extremely quickly, allowing themto become global. International financial regula-tions could not keep the pace with these fastchanges. Due to their private activities, hedgefunds are in fact exempt from certain equitymarket regulations and data reporting obliga-tions, and since they are operated with extreme-ly high capital gearing, they increase and trans-fer risks exponentially across global financialmarkets, increasing their vulnerability.

The analysis of the structure of theHungarian banking market verifies a gradualappreciation among market players' competi-tion strategy considerations for new financialdesigns that are capable of servicing customerdemands efficiently in an oligopolistic marketenvironment. The expansion of these financialinnovations is influenced by a number of fac-tors both on the supply and the demand side.The constant deepening of the financial sys-tem and market expansion potentials lyingwithin has so far meant a relatively low urgefor banks to expand the range of financialinstruments. On the demand side, a so far sub-dued interest in more complex financial prod-ucts in the scope of retail customers,29 howev-er, is in conjunction with the general level offinancial literacy. Investors do not have appro-priate product information, are unable tounderstand yield and risk correlations of morecomplex designs or exchange rate risks. Theirfinancial decisions lack complex deliberation,often reaching them on the basis of a single

Chart 5

DEVELOPMENT OF PRE-TAX PROFIT AND ITS MAIN COMPONENTS

Forrás: MNB, http://www.mnb.hu/Engine.aspx?page=mnbhu_stabil&ContentID=10897

HUF bn HUF bn


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factor (yield, monthly instalment, etc.).30 As aconsequence of limited financial literacy, someaversion to electronic financial transactions isevident, and mistrust is also reflected indomestic card usage patterns.

The oligopolistic structure of theHungarian banking sector should be regardedas a long-term condition, and it cannot be ruledout that the market consolidation will intensifyfurther, while more balanced power positionsare developing in certain segments. The inten-sifying competition in the banking sector willcause interest margins to decline deeper, there-fore, in order to maintain profitability, somecredit institutions will have to cut back opera-tional costs and also to increase the ratio of feeand commission income against the dominance

of interest income. For this purpose they haveto bolster the sales of higher-yield, more com-plex banking products and services, imple-menting new instruments and financial innova-tions. All this requires that these products becommunicated to customers in an increasinglytransparent form, not the least because ofattempts by the regulatory authority to makebanking processes more transparent.

In line with international trends, the suc-cess of the Hungarian banking sector is vitallydecided by the success of finding an innovationenvironment31 where the renewal of the rangeof products and services is increasingly fuelledby a competitive edge in prices and servicequality driven by customer demands and theendeavour to be distinguished from rivals.

1 A general corporate competition environment isassumed when market structure is analysed; the cor-relations and rules shown here are basically valid inthe scope of banking and finances, as well

2 A monopolistic market may be evident on thedemand side, too; and the specifics described here areapplicable in this case, only with a different cast

3 Reuter, F. J. (1970): Forschungspolitik undForschungsplanung, Duncker und Humblot Verlag,Berlin, page 38

4 See in detail: Machlup F. (1967): Oligopol undFreiheit, ORDO Jahrbuch für die Ordnung vonWirtschaft und Gesellschaft, Bd. 18.

5 Schumpeter, J. (1980): A gazdasági fejlõdés elmélete:Vizsgálódás a vállalkozói profitról, a tõkérõl, a hitel-rõl, a kamatról és a konjunktúraciklusról [Theory ofeconomic Development: A Study into CorporateProfit, Capital, Loans, Interest, and EconomicCycles], KJK, Budapest, 320 p.

6 Tabbert, J. (1974): Unternehmensgrösse, Markt-struktur und technischer Fortschritt, Göttingen,page 5

7 Tabbert, J. (1978): page 15

8 http://www.pszaf.hu/engine.aspx?ResourceID=pszafhu_bankinfo_2007_4

9 Except for MFB [Hungarian Foreign Trade Bank],EXIM, and KELER Zrt. [Central Clearing Houseand Depository Co. Ltd.]

10 OTP Bank, MKB Bank [Hungarian Foreign TradeBank], K&H Bank, CIB Bank, RAIFFEISENBank, ERSTE Bank Hungary, UniCredit BankHungary

11 Lakossági Pénzügyi Szolgáltatásokat VizsgálóSzakértõi Bizottság [Expert Committee Scruti-nising Retail Financial Services] (2006): Javaslatoka lakossági bankszolgáltatások problémáinakkezelésére [Propositions for managing problemsdetected in retail banking services], Budapest,page 18 – http://www.meh.hu/tevekenyseg/tevekhirek/20070131.html

12 See same, page 5

13 http://www.onpulson.de/lexikon/finanzinnovatio-nen.htm

14 http://www.flyingfox.de/foxlex/index.php/ Finanz-innovation

NOTES

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15 Speech Chairman Ben S. Bernanke To the FederalReserve Bank of Atlanta's 2007 Financial MarketsConference, 15 May 2007 – http://www.federalre-serve.gov/newsevents/speech/bernanke20070515a.htm

16 Special Purpose Vehicle

17 http://www.zeit.de/1988/43/Verruecktes-Spiel-auf-Zeit

18 Entzauberte Finanzinnovationen – ErnüchterndesFazit, Handelsblatt, 6 April 2008 – http://www.handelsblatt.com/News/Unternehmen/Banken-Versicherungen/_pv/_p/200039/_t/ft/_b/1413143/default.aspx/entzauberte-finanzinnovationen. html

19 Párhuzamos világaink [Parallel worlds], Piac &Profit [Market & Profit], Years XII., February 2008,page 5: “a huge industry has developed, a huge sec-ondary virtual world where profits have to be gen-erated some ways… The demand for profit and thecompulsion to invest have jointly created a multi-tude of investment funds and investment structuresthat are completely intransparent for the investor”.

20 For instance Pioneer Profitmax Alapok Alapja[Pioneer Profit Max Fund of Funds], RaiffeisenPrivate Banking Pannonia Alapok Alapja [RaiffeisenPrivate Banking Pannonia Fund of Funds]

21 MNB Jelentés a pénzügyi stabilitásról [NBHReport on Financial Stability] (April 2008), page 79http://www.mnb.hu/Engine.aspx?page=mnbhu_stabil&ContentID=10897

22 For instance UniCredit Piaci Optimum Alap[UniCredit Market Optimum Fund], Aegon ÓzonÉves Tõkevédett Származtatott Alap [AegonOzone Annual Capital-guarantee Derivative Fund],MKB Zöldbolygó Tõkevédett származtatott Alap[Hungarian Foreign Trade Bank Green PlanetCapital-guarantee Derivative Fund ], Erste Top 10Kötvény Alap [Erste Top 10 Bond Fund]

23 For instance Befutó Tõke- és Hozamvédett Alap,Világszám Tõke- és Hozamgarantált SzármaztatottAlap, Erste Garantált Kötvény, Raiffeisen UniverzumTõke- és Hozamvédett Származtatott Alap

24 Dare to be different: Why banking innovationmatters now (2007), IBM Global BusinessServices, http://www-935.ibm.com/services/us/index. wss/ibvstudy/gbs/a1025350?cntxt=a1000043

25 http://www-935.ibm.com/services/us/gbs/bus/pdf/ibm-podcast-dare-transcript-final.pdf, 15 March2007, pp 1–3

26 [NBH Report on Financial Stability] (April 2008),page 67

27 See same, page 68

28 Ms Farkas, Barbara: Pályázatok: több bank is újított[Application: Banks come up with something new],Világgazdaság [World Economy], 10 April 2008,page 6

29 A survey made by market research company GfKHungária for The Wall Street Journal Europe indi-cates that the ratio of customers investing inshort- and long-term bank deposits is 11 per centin Hungary, while the corresponding figures inWestern Europe, and the Czech Republic are 43per cent and 27 per cent, respectively. One percentof the Hungarian population invests in stock andthe same ratio is registered in stock funds (thecomparative figures in Western Europe are 11 percent and 9 per cent, respectively). In Hungary, lifeinsurance and pension funds have an investmentratio of 10 per and 5 per cent, respectively, whilethe respective indicators in Western Europe show25 per cent and 14 per cent. According to the sur-vey, an even three-fourths of the Hungarianhouseholds have no savings whatsoever, while thecorresponding figure in Western Europe is 40 percent. – http://origo. hu/uzletinegyed/befek-tetes/20071214-feher-hollo-a-magyaroknal-a-penzugyi-befektetes-gfk.html

30 See in detail: Ms. Kotulyák, Éva: A banki szolgál-tatásokról [Of banking services], Cégvezetés[Corporate Management], 11 December 2007

31 Cline, K. (2004): Institutionalizing Innovation,Banking Strategies, September/October 2004,http://www.bai.org/bankingstrategies/2004-sep-oct/kenworthy/index.asp


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CARLTON, D. W. – PERLOFF, J. M. (2003): Modernpiacelmélet [Modern Market Theories], Panem,Budapest

EHRLICH, E. – FANELLI, D. (2004): The FinancialServices Marketing Handbook – Tactics andTechniques That Produce Results, Bloomberg Press,Princeton

FREI, F. X. – HARKER, P. T. – HUNTER, L. W. (1998):Innovation in Retail Banking, The Wharton School,University of Pennsylvania

HULL, J. C. (1999): Opciók, határidõs ügyletek ésegyéb származtatott termékek [Options, Futures, andOther Derivatives], Panem – Prentice-Hall, Budapest

JORION, P. ((1999): A kockáztatott érték [Value atRisk], Panem, Budapest

KOHN, M. (1998): Bank- és pénzügyek, pénzügyipiacok [Financial and Banking Affairs, FinancialMarkets], Osiris, Nemzetközi Bankárképzõ [Inter-national Training Centre For Bankers], Budapest

MACHLUP, F. (1967): Oligopol und Freiheit,ORDO Jahrbuch für die Ordnung von Wirtschaft undGesellschaft, Bd. 18.

REUTER, F. J. (1970): Forschungspolitik undForschungsplanung, Duncker und Humblot Verlag,Berlin

SCHUMPETER, J. (1980): A gazdasági fejlõdéselmélete: Vizsgálódás a vállalkozói profitról, a tõkérõl,

a hitelrõl, a kamatról és a konjunktúraciklusról[Theory of economic Development: A Study intoCorporate Profit, Capital, Loans, Interest, andEconomic Cycles], Közgazdasági és Jogi Könyvkiadó,Budapest

SEITZ, T. (Hrsg.) (1989): Wirtschaftliche Dynamikund technischer Wandel, Gustav Fischer Verlag,Stuttgart-New York

SIKLOS, P. L. (2003): Money, Banking, and FinancialInstitutions – Canada in the Global Environment,Fourth Edition, McGraw-Hill Ryerson

TABBERT, J. (1974): Unternehmensgrösse, Markt-struktur und technischer Fortschritt, Göttingen

Dare to be different: Why banking innovation mat-ters now (2007), IBM Global Business Services,http://www-935.ibm.com/services/us/index.wss/ibvstudy/gbs/a1025350?cntxt=a1000043

Expanding the Innovation Horizon: The GlobalCEO Study 2006, IBM Global Business Services.March 2006, http://www.ibm.com/bcs/ceostudy

MNB Jelentés a pénzügyi stabilitásról [NBHReport on Financial Stability] (April 2008), Budapest

The paradox of Banking 2015 – Achieving more bydoing less (2005), IBM Institute for Business Valuehttp://www-935.ibm.com/services/us/index.wss/ibvstudy/imc/a1022912?cntxtId=a1000043

LITERATURE


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O

Ádám Demény

The central budget management systemand the impact thereof

One of the key elements of the state budget reformis that of the execution of the budget, making theutilization of public funds and EU subsidiesmore transparent and controllable. The purposeof the concept of the budget management systemdeveloped by the Ministry of Finance is to intro-duce, besides the reorganization of the Treasuryprocesses, changes in the regulatory system for thecentral budgetary institutions such as ministries,government offices, central offices, law enforce-ment agencies and other background institutionsbased on the reporting of preliminary and com-prehensive commitments, in order to support thereform process in this way as well.

According to the plans, the idea is to leavethe fundamental professional competenceswith the central budgetary institutions but atthe same time, to create the opportunity forthe enforcement of financial-budgetary con-trolling by applying a strict controlling system,from the planning of the budget through finan-cial performance to final accounts.

As a relevant element of the state budgetreform, along with the partial modification ofthe regulatory environment, it makes sense todevelop a centralized and integrated systemwhich uses state-of-the-art IT solutions. Thiscomplex system allows that the management ofthe economic events of the budgetary institu-tions is followed through their entire lifecycles

in such a way that the system is capable of con-tinuously supplying aggregated data on the uti-lization of the available funds.

The migration of the state-state, citizen-state and state-enterprises relationships intothe electronic space would, in turn, facilitatethe formation of an efficient state as a serviceprovider.

BRIEF SUMMARY OF THE CURRENT SITUATION

The Treasury organization of the state

The implementation of the Treasury tasks playsa critical role in the macro-level management ofthe public finance system. The period that haselapsed since the development of theHungarian Treasury model in 1996 has proventhat the existence and role of the HungarianState Treasury is indispensable in the disburse-ment and collection of public funds in the con-text defined by the laws.

The IT systems of the Hungarian StateTreasury that used to support the originalTreasury tasks, which function even now, most-ly function according to the needs defined 10years ago. These systems are obsolete both onthe level of process management and on that of


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technological and technical solutions, they can-not efficiently fulfill the specialized profession-al requirements of the present.

As a result of non-integrated and decentralizedoperations, the consistency of information canonly be ensured with difficulty, which results inthe low standards of information supply.

As a result of the lack of the comprehensive-ness of undertaking commitments and that ofperformance-based financing, there is possibilityfor overspending, and the utilization ofunplanned income items without control,which cannot be planned on the level of thestate budget. The current system is not suitablefor the reception of electronic suppliers' andservice providers' invoices, furthermore, it isnot capable of handling e-money either.

The systems which are fundamentally basedon the flow and processing of paper-based trans-action documents, besides their low cost-effi-ciency, do not support the enforcement of theadministration cut program announced in theframework of the state budget reform, on theone hand, and they make it almost impossibleto ensure up-to-date, truthful information, onthe other hand. This means, in practice, thatthe handling of economic events requires themaintenance of a higher than necessary volumeof human resources at the Treasury.

Budgetary institutions

The accounting (financial management) sys-tems that can be freely chosen by the budget-ary institutions, which are non-centralized andwhich operate in a non-uniform structure areon very different levels of development on theone hand, and they do not allow the represen-tation of up-to-date figures of the centralbudget on the level of the general ledger, on theother hand. The information aggregated fromthe institutional levels and those on the level ofthe national economy usually do not agree, as a

result of the differences in the institutional andTreasury records, the periodical reconciliationsof which generate significant and superfluousextra efforts. In the past few years, a large pro-portion of the ministries and central budgetaryinstitutions have implemented integratedfinancial-accounting systems (various ERP1

systems) from their own resources, as theintroduction of the Centralized Payroll System(Hungarian abbreviation: KIR), whichdemanded considerable sacrifice, was not fol-lowed by the implementation of a system per-forming centralized accounting tasks.

The various types (financial, general ledger,tangible assets module) of integrated financialmanagement systems replaced and implement-ed at a number of organizations mostly rely onIT support whose standards are in line with therequirements of our age, however, no interop-erable relationship with the more backwardcentral Treasury systems is possible. The insti-tutions continue to conduct significant paper-based dataflow, and the underlying registrationsystem also has to be maintained redundantly.

In order for the financial management tasksto be integrated on the highest possible level atthe budgetary institutions, as well as to makethem operate with the lowest possible staffcosts, with a significantly lower level of paper-work, a complex central IT system, which iscapable of handling both the Treasury and theinstitutional management tasks in the samesystem, needs to be developed.

THE NECESSITY OF THE INTRODUCTIONOF A NEW SYSTEM SUPPORTING THEPROCESSES OF THE EXECUTION OF THE BUDGET

It is the reform of the execution of the centralbudget, the rendering of the management ofpublic finances transparent and entirely con-trollable, the simplification and digitalization


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thereof that justify the development and imple-mentation of a new system that supports theexecution of the budget. The design of a new,centralized, real time system called the BudgetManagement System (Hungarian abbreviation:KGR) was developed as part of the state budg-et reform2.

In order to be able to develop a complex, up-to-date Treasury system,

• which monitors the execution of the budg-et, the spending of public funds in a con-trollable way, by using a project approach,

• which provides up-to-date and integratedinformation to each relevant player on theappropriate level,

• which is efficient and easy to operate,the views on the operation of such a systemshould be changed, both with regard to the"Treasury approach" and the regulatory sys-tems, and with regard to the applied IT solu-tions.

The most important task of KGR is to"remove" Treasury from the economic space, inorder to ensure that the goals set in the con-vergence program, the New HungaryDevelopment Plan, as well as in the chapter-level IT strategy of the Ministry of Financeshould be achievable by incorporating the tasksrelated to cashflow and financial managementinto this organization.

The KGR system means a change withregard to both its functionality and maturity inthe overall network of institutions of the cen-tral budget. According to the objectives, thesystem will be applied for both the appropria-tions of the institutional budget and thosemanaged by the chapters. However, theplanned regulation does not aim to withdrawprofessional and financial management compe-tences from the institutional system. KGR firstof all focuses on getting the current principlesof financial management observed and on con-trolling the observation, by also modernizingoperation and sometimes concentrating the lat-

ter and applying electronic payment methods.The transformation of regulation and the mod-ernization of the operational mechanism offinancial management should, through theKGR system, contribute to the higher levelperformance of the professional tasks dealtwith at the institution.

Unless an application system placed onentirely new foundations and implementedwith up-to-date technology and knowledge, aswell as a system that serves the former withstate-of-the-art technologies, are implementedas soon as possible, the operating risk willincrease further, which may involve unforesee-able consequences. As it also turns out fromthe above, there are no real alternative solu-tions to remedy the current situation. The cur-rent system cannot be developed further. Theup-to-date solution will definitely be the oper-ation of integrated, on-line, real time and com-mon databases, where each data will only beentered into the system once, at the placewhere it was generated.

THE ELEMENTS AND BREAKDOWN OFTHE BUDGET MANAGEMENT SYSTEM

The complexity of the system outlined so farcomprises the financial government, the centralbudgetary institutions and the Hungarian StateTreasury, which is the state bank that performsthe financial tasks. The modules that serve thefunctionality of KGR can be broken down intofour interrelated groups:

• IT reorganization of specialized Treasurysystems,

• the implementation of a uniform, integrat-ed institutional financial-accounting sys-tem,

• the implementation of a uniform budgetplanning system,

• the development of a public finance man-agement information system.


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Reorganization of the Treasury systems

The replacement of the current Treasury ITsystem at the same time creates an opportuni-ty for the reorganization of tasks and process-es and for putting more-up-to-date IT sup-port in place. Besides the implementation of aclassical bank account management systemcalled the BSZM module, the comprehensiveimplementation of the appropriation manage-ment (EGM) module and the commitment(KTM) module will be important elements ofthe KGR as its main functions, by which theelectronic data connection between the budg-etary institutions and the Treasury can beestablished.

The tasks of EGM include the registration ofbudgetary appropriations and the modifica-tions thereof according to the decrees or lawsin which these changes were ordered, as wellas, based on these, the execution of the open-ing of the subsidy limits of the appropriationsmanaged by the institutions and the chapters.The services provided by the module are asfollows:

• acceptance and registration of the originalappropriations defined in the Budget Actfor the year in question on the basis of thedata supplied by the Ministry of Financeand the Treasury budgets submitted by thechapters;

• reception of the modifications of theappropriations according to the levels ofcompetence, from the appropriation own-ers and those who have the authority toperform modifications;

• operation of the decision registration sys-tem containing the modifications in thecompetence of the National Assembly, thegovernment and the Ministry of Finance;

• execution of the subsidy limit openings;• connecting the current appropriations

with the KTM system and its subsystems;

• performing general ledger postings andensuring detailed analytical records for theinstitutional financial management sys-tems;

• performing special handling tasks (such asblocking, the retention of the net financ-ing subsidy limit);

• providing information to the appropria-tion owners and the management informa-tion systems.

The relevant novelty in this area is that themodifications of the appropriations can only beaccepted and confirmed on-line and/or inanother electronic form in the future.

KTM is responsible for managing the commit-ments undertaken and performed by the centralbudgetary institutions, the budgetary chapters,the appropriations of the national economy,the social security funds and the separated statefunds. The services provided by the module areas follows:

• reporting of the intention to undertakecommitments for the appropriations (forthe scope defined in the law) under theEGM system, controlling and approvingthe acceptability of the commitment,issuance or rejection of a commitmentnumber;

• registration of the expense and incomecommitment of the current year;

• registration of long-term expense commit-ments;

• at the time of launching the transfers, thepreliminary control of the commitmentand/or the availability of the appropriationcoverage, as well as public debt monitoringin the case of payments from certainappropriations;

• registration of information related to therealization of income and expenses.

BSZM is responsible for keeping the accountsof the Treasury and the current account holdersas defined in law, the accounts to be used forthe financial execution of the tasks defined by


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the government and the settlement accounts ofthe national economy. It is also BSZM'sresponsibility to ensure the cash supply in anintegrated, multicurrency (also supporting theintroduction of the euro) banking system,which is independent from branches. The serv-ices provided by the module are as follows:

• reception of subsidy limit openings fromthe EGM system;

• reception of budget-related transactionsfrom the KTM system, feedback on theperformance/rejection of transactionsapproved by the KTM system in theaccount keeping system;

• handling of transactions directly receivedby the BSZM system (income, prompt col-lections, costs related to account keeping);

• liquidity coverage examination and debit-ing, as well as separation of coverage(blocking), for example when launchingforeign currency transfer orders;

• ensuring the cashier's desk function(cashier's desk, vault, preliminary reporting);

• supplying on-line information (transac-tions launched and received) to liquiditymanagement for the calculation of themomentary portfolio of the KESZ(Standard Treasury Account);

• preparation of aggregated and detailedreports on the accepted but not yet per-formed transactions;

• ensuring posting to the institutional finan-cial management systems on the basis ofthe defined general ledger correlations;

• preparation of account statements (differ-ently by client types) electronically, or ifnecessary, on paper;

• public debt monitoring of the eligible enti-ties on the basis of predefined viewpoints,rejection of the order if necessary;

• satisfaction of statutory requirementsaimed at the prevention of money launder-ing, turnover monitoring, data supply.

Besides the three main modules (BSZM,EGM and KTM) of the Treasury systems,which are visible and tangible to all the players,some other supporting subsystems are alsonecessary.

In the reform steps of executing the budget,an important role should be fulfilled by themanagement of cost liquidity, which is sup-ported by the liquidity management module(LMM module) of the KGR concept. Thefinancial transactions of the current day arereviewed by liquidity management and the lat-ter may dispose of the current day or deferredlaunching of these transactions by taking theavailable funds into account even item by item.

With regard to the central budget, theprocess of financial performances is recordedand its critical majority is realized electronical-ly (in the form of bank transfers), this is whythe implementation of electronic accountacceptance (EBPM module) may mean a gen-uine change of paradigm in this area. The pointof the EBPM system is that the accounts, byexcluding paper-based transaction documents,are passed from one ERP system to the otherelectronically, by applying a central EBPMmodule.

With regard to the fact that the return andcurrent account systems of APEH (theHungarian Tax and Financial ControlAdministration) and VPOP (the HungarianCustoms and Finance Guard) are not connect-ed to the Treasury registration systems, i.e. the

The introduction of the Treasury modulesof KGR makes it possible to replace the slowsolutions based on paper-based transactiondocuments, using manual data entries andrequiring a high volume of resources in thearea of the modifications affecting the annu-al appropriations to be executed in one'sown competence, as well as in relation to thereporting of commitments to the Treasury.


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comparison of the turnover of the nationaleconomy accounts managed by the Treasuryand the data of the return processing systemsmanaged by the tax authorities requires signifi-cant efforts, a module responsible for control-ling the returns and performances (BTM mod-ule) should also be built up within the KGR.

Introduction of a uniform institutionalfinancial management system

According to the current regulation, the organ-izations of the Treasury may decide, in theirown competence, on the selection of theaccounting system that they wish to apply,which are sold in the market, and which are, inmany cases, developed by relying tools that areconsidered obsolete these days. As a result, thesoftware applied for this purpose by the indi-vidual institutions is very diverse, thus therecords kept by these organizations are notuniform either.

In the course of the implementation of theinstitutional accounting module of KGR(IKM module), integration between theTreasury and the institutional tasks can bedeveloped. The application of a single, uniformfinancial management and administration sys-tem that refers to the central budget as awhole, allows that the tasks, as well as therelated obligations and responsibilities of theindividual institutions related to financial man-agement do not change.

IKM is responsible for meeting the reportingobligation of the organizations of the publicfinance system, as well as its obligations ofbookkeeping meant to support the financialstatements, especially by enforcing the princi-ples of unity, continuity and transparency, bytaking the rules of budgetary financial manage-ment into the account to the maximum extent.Furthermore, it is also responsible for bookingthe data related to the KESZ Treasury entities,

the national economy accounts and the currentaccount holders. The following services areprovided by the module:

• performing the tasks of preparing thefinancial statements and the balance sheet;

• ensuring data consolidation in the individ-ual subsystems of the public finance sys-tem and between the individual subsys-tems of the public finance system;

• application of a comprehensive chart ofaccounts extending to each subsystem,including the national economy accounts;

• it should satisfy the data supply require-ments and the management informationneeds.

In order to be able to prepare uniform, andin consequence, reliably aggregable statementson the level of the state budget, such a generalledger structure should be applied which isobligatory for each budgetary organization to apredefined level. Of course, if it is justified bythe financial management of the individualorganizations, further breakdowns to beapplied individually should be allowed, withoutchanging the uniform structure.

The implementation of a certain economicgovernance system called the ERP system3 inthe nearly 700 central budgetary institutionsrequires, beyond development, enormous orga-nizational, management and logistical efforts,thus the roll-out process meant to ensure com-prehensive use may take even as long as 4–5years. This means that the KGR concept can-not be implemented in a short time, even with-out the implementation of the local govern-ment subsystem.

As consequence of the points mentionedabove, the implementation of the other KGRmodules can be performed sooner that that ofthe IKM module, this is why a service that canbe used on a uniform platform, i.e. an interfaceconnection, should be made available to theappropriation owners until its implementationis completed, in order for them to be able to


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perform their tasks related to commitments,appropriation management and cashflow in areal time, online form.

System supporting budget planning

One of the main tasks of budget managementis to take care of the process of budget plan-ning, which is generally performed by eachchapter, mid-level management and the subor-dinated budgetary organization with scarce ITsupport of very diverse quality year by year.However, no state budget-level planning sys-tem extending to the entire budgetary sectorhas yet been implemented. By introducingKGR, there seems to be a historical chance forthe implementation of a centrally operatingBudget Planning System (KTR module) aimedat managing the process of planning the budg-et, with integrated processes and with a uni-form and appropriate authorization system,besides the transactional systems related tofinancial management. The target scope may bethe support of the breakdown (redistribution)of the Treasury and elementary budgets,besides the preparation of the proposed budgetplan. In current practice, from among the well-known planning logics, it is the top-down ver-sion that is used most widely, however, anincreasingly larger space should be given to theadded bottom-up logics as well, which mixedsolution is called the contraflow planning sys-tem in technical literature. Planning is a multi-dimensional process in all respects and we haveto take it into account that KTR has to be capa-ble of supporting the task-based planning log-ics, whose use will very probably become wide-spread in the future, which, in practical terms,means a new dimension of the planning andreporting process.

As a result of the introduction of the system,the planning process will become faster, thedata will be transferred automatically, the man-

ual workload can be reduced, data consistencyand data quality will improve. In such a way, therequired analyses can be performed faster, thetime spent on the process technology willdecrease, which may result in the strengtheningof a genuine foundational planning approach.

Management Information System

The implementation of the KGR project bythe government does not only project the pos-sibility of creating a smaller and more effi-ciently operating state but it also supports thesimple and fast solution of accessing manage-ment information. It is also an old dilemma torelease the information asymmetry betweenthe supporting and the supported organiza-tions, which is due to the fact that informationis generated on the side of those who needsupport, and the decision-makers can mostlyrely on the information generated on the appli-cants' side in order to ensure the appropriateallocation of the funds. It is a goal to developsuch a unified, on-line, state budget-level man-agement information system built on thefoundation of KGR, where the quality of dataand the speed of information delivery are con-siderably more favorable than in the currentcircumstances and where this system providesdata required for decision-making to the vari-ous supervisory and management levels on thebasis of its own refined authorization system.Within the KGR system, the InformationSupply and Evaluation System (ISZM module)was defined as a separate module but it sup-ports management in the making of decisionsby applying the data warehouse technologyfrom the overall system.

The ISZM module is aimed at consolidating,analyzing, extracting, storing in optimized timeseries, as well as the provision of informationstored in the separate modules of the systemand those coming from external information


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systems, both towards the internal and externalusers in the form of OLAP4 and standardreports. By generating real time information, itbecomes possible to realize budget-level datasupply (daily reports, etc.) as early as on thecurrent day, even by ensuring an opportunityto the responsible professional managers of thefinancial sector to query for, or download therequired statements immediately.

KGR overview diagrams

On the one hand, charts 1 and 2 show whatmodules the individual user groups of the KGRare linked to, on the other hand, the mainprocesses of the operation of the system, aswell as the major links between the modules arewell visible in them.

THE IMPACT OF KGR ON THE BUDGETARYORGANIZATIONS

According to the points made so far, the imple-mentation of the system at the same timemeans the implementation of the reform of theHungarian State Treasury, the positive impacton the financial government is also visible,which will practically be tangible in supportingmanagement in making decisions through thealmost unlimited accessibility of the informa-tion but its impact on the budgetary organiza-tions is much more complex than this.

Lack of integration at the economicareas of the institutions

Institutional financial management, which is byfar not ideal, struggles with the lack of integra-tion opportunities and they solve the extratasks arising from the latter by involvingunnecessary resources. The harmony, which

seems to be natural between the individualareas, has not developed in several other areas,due to traditional or other reasons. Table 1shows the correlations between the integrationopportunities and the KGR system.

For releasing the negative effects arisingfrom the lack of integration, the budgetaryorganizations have given various responses byrelying on their own resources to date but onecan only provide a uniform solution for themain areas in a centrally managed form. TheKGR concept wishes to create opportunitiesfor filling the gap without the integration ofthe tasks performed by the Payroll System(KIR), for the time being, without comprehen-sively reckoning with the processes of theinternal specialized systems.

Positive and negative impacts

The KGR project represents a significant barri-er and retentive power against free financialmanagement in protecting the integrity of theindependence of institutional financial manage-ment. On the one hand, it creates the opportu-nity for the introduction of commitment rulestied to comprehensive preliminary reporting,which now reduces the freedom of the institu-tions to procure, invest and manage humanresources. On the other hand, it supplies con-tinuous information on institutional financialmanagement (the contracting practices, thepotential wasting of money) already at themoment of occurrence but later, it also givescontinuous information to the supervisoryauthorities with access rights from the analysesprepared from the time series on-line datawarehouses.

The project affects the processes related toappropriation management, the undertakingof commitments, the bookkeeping tasks per-formed by the appropriation owners, dailyliquidity management, as well as the keeping


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Chart 2

LOGICAL STRUCTURE OF THE MODULES OF THE BUDGET MANAGEMENT SYSTEM

Chart 1

MODULES AND USERS OF THE BUDGET MANAGEMENT SYSTEM

Plans

KGR, i.e. the Budget Management System

Modified appro-priations

Managementtasks

Banktransfers

Orig

inal

app

ro-

pria

tion

Tran

sfer

or

ders

Fina

ncia

l per

-fo

rman

ces

TEMBudget

planning

EGMAppropriationmanagement

Invoices to betransferred

LMM

KTRBudget Planning

System

EGM AppropriationManagements

System

BSZM MulticurrencyBank AccountManagement System

KTM Commitment andContract Registration

System

IKM 1. Chapter-based,Institutional Bookkeeping

System 2. National econo-my accounts

LMM LiquidityManagement

System

BTM Returns andPerformances Control

Module

EBPM ElectronicAccount Acceptance

and PresentationSystem

Central budgetary entities

KVTR

GIRO, post office, e-pay-ment systems, NBH

APEH (the HungarianTax and Financial

ControlAdministration) and

VPOP (the HungarianCustoms an Dinance

Guard) systems

Original appropriation

Transfer

ISZM Information Supply and Evaluation System (for government, Ministry of Finance, audit organizations)

Queribilitiy, listability

Extraordinary direct payments

Statements to be downloadedelectronically

Traditional accounts

e-accounts

Undertaking of commitments, transfers

Queries, lists, other information

modifications

Chepter, government, institution

Appropriationowners

Partners

LMMLiquidity

management

BSZMBank account

manager

IKMInstitutionalaccounting

Accountingtasks

Institutions, appropriation owers (including: MÁK, i.e. the Hungarian State Treasury)

Decision-makers MÁK, i.e. the Hungarian State Treasury

ISZRInformation suplly

Commitments,Contracts, Accouts


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of the accounts of the appropriation owners,and the IT systems that support the perform-ance of these tasks. Thus, the project willresult in increasing the performance of stateadministration and public utilities, in reduc-ing operating costs and rendering administra-tion faster and more efficient. By applyingKGR, the current paper-based transactiondocuments can be replaced by electronic dataconnections.

The period following the implementation ofthe project is anticipated to see the followingimpacts, which may be judged differently fromeach aspect.

Better information flow: faster and better-founded decisions

On the level of the national economy, mak-ing the processes of executing the centralbudget electronic will contribute to the estab-lishment of an efficient state as a serviceprovider and the institutions thereof.

A more efficient operation of the Treasury As a result of the reorganization of the

Treasury processes, as well as the simplificationof the processes, the isolated systems and themanually produced reports will cease to exist,and the majority of data processing will disap-pear on both the institutional and the Treasurysides.

Electronic communication between theTreasury and the clients

After the implementation of the centralizedsystem, the termination of the practice ofphone and paper-based professional adminis-tration between the Treasury and its clients and

the introduction of electronic data turnoverwill also mean significant cost savings.

Electronic acceptance of invoices The electronic acceptance of invoices will

also result in considerable savings, as the relat-ed administrative burden will decrease as aresult of automation.

Reduction of operating costs IT operating costs will also be substantially

reduced as a result of the renewed infrastruc-ture, as the maintenance of modern technologyrequires less resources and even this reducedworkload will be managed with a high level ofcentralization.

Paper saving On-line connections bring about consider-

able savings on paper, the replacement ofpaper-based transaction documents andaccount statements by the electronic form willalso mean savings on postal and storage costs.

Supporting budget planning In the course of the uniform, centralized IT

support provided to the annual state budgetplanning process, the well-foundedness of thedecisions will improve, the simulations of sev-eral versions of the budget plan can be per-formed at the same time, and the time require-ment of the technical tasks will also decreaseand this will involve an increase in the amountof time that can be used for performing gen-uine planning tasks.

Market concentrationInstead of the financial-accounting sys-

tems that have been freely selectable to date,the budgetary ERP market will be replaced

1. táblázat

CORRELATIONS

Integration oportunity To be solved in KGRIntegration of the institutional financial and accounting areas

Integration of the institutional economic tasks and the Treasury tasks

Integration of the institutional payroll and accounting areas xIntegration of the institutional financial management tasks and the other specialized systems x


643

by a uniform system in the mid-term, whichmay result in significant savings as conse-quence of the centralization of licence feespaid to date.

More intense supervisory activities The information asymmetry between the

supporting and the supported organizationswill decrease to a great extent, thus a businessrequesting the government or the chapter foradditional subsidies will have more difficultyin obtaining extra resources that are not ade-quately justified, which is one of the primarycriteria of efficient financial management.

Risk factors

The planned project requires increased riskanalysis due to its professional compositionand volume. Before the actual launching of theproject and the completion of the systemdesign, the following key risk factors can beidentified.

Regulatory environment The entire development cycle will be con-

ducted in a field of moving targets, as the place-ment of government financial management onnew foundations and the development of thereform concept of the latter go parallel with theproject activities. Thus, in the course of thedevelopments, one should rely on the changemanagement activities to a higher than expect-ed extent.

Project sizeThe planned developments fall in the catego-

ry of "highly complex projects". KGR consistsof several, relatively independent subsystems,between which, however, there are importantsystem correlations, and KGR as an integratedsystem also provides some important services.No system of such a size has yet been devel-oped and implemented in a concentrated effortin Hungary but we can rely on internationalexperience in this respect.

Professional supportWe regard the task of developing KGR as a

specialized economic task in the first place andas an IT task only in the second place. The cen-tral modules of the KGR system are to be oper-ated by the Hungarian State Treasury from aprofessional aspect. The professional compe-tence on the client side is to be available at theappropriate time and place as early as in theperiod of developments, which means theinvolvement of extra resources during the proj-ect period in order to ensure the smooth per-formance of the daily tasks of the institution.

Implementation risks The modules of KGR are not going to be

implemented simultaneously. During themigration and implementation of the individualmodules, the interruptions that may potential-ly occur in the institutional and centralprocesses of financial management can beavoided by accurate planning and timing.

POSSIBLE DIRECTIONS OF PROGRESS

According to the concept outlined above, in afew years' time Hungary will see the availabili-ty of a Treasury system supported by modernIT technology and a uniform, centralizedfinancial-accounting system governed by theeconomic events and supporting the financialmanagement and Treasury tasks of the institu-tions, for the central budgetary organizations.This, at the same time, provides strict controlfor the utilization of the budgetary funds.However, this opportunity should not beextended to the institutional systems of thelocal government and the sponsors thereof inthe first phase. The reasons for this mayinclude, on the one hand, that the risks ofimplementation may exponentially grow evenif only the high number of such institutions istaken into account, on the other hand, theimpact of the central government on this sub-


644

system can only be regarded as limited, andthird, the missing reform of local government-level budgetary regulation appears to be anobstacle as well.

When the system is built, the opportunityfor extending the use of Budget PlanningSystem should be created first, and then that ofthe other modules of KGR, on the basis of fur-ther analyses, to the local government sector inthe future.

As a new module of KGR, the implementa-tion of an integrated human resources registra-tion and payroll system should also be exam-ined, as the currently used non-integrated solu-tion causes a lot of problems for the institutions.

SCIENTIFIC RESULTS

The implementation of a centralized and uni-form system with integrated processes, as wellas its comprehensive operation for a few yearsare the preconditions of the realization of theconcept on the budgetary financial manage-ment and the state budget planning reform. Itis from this experience that various bench-marks can be derived and defined, by usingwhich the further transformations (reformsteps) can be planned more precisely.

In the area of public finances, similarly to themodern systems applied in the competitive sec-tor, the implementation of a completely stan-

dardized, integrated corporate governance sys-tem still seems to be unrealistic in the mid-term. On the one hand, it is only the centralstate administration, and perhaps the socialsecurity subsystem that continued to be in thefocus of the decisions, i.e. the independence ofthe financial management of the local govern-ments will not be affected by the obligatory useof the Treasury systems in the near future, witha few exceptions. Furthermore, the payroll(KIR) system introduced earlier (but still notcomprehensive), as well as the independenthuman resources system (HR) not related tothe payroll system, whose development wasstarted by isolated efforts, will, for the timebeing, be missing from the scope of the inte-grated financial management system of thebudgetary organizations.

While the saying, according to which thepossession of information is a major power fac-tor, continues to be true, we can declare, withincreasing conviction, that you can only man-age and govern efficiently if this information isshared as well. This means that a single central-ized financial management system, rules thatare interpreted uniformly, and a managementinformation system relying on a common data-base may greatly support the efficiency ofmanagement at the supervisory organizationsof the budgetary institutions (including mid-level management, chapter and governmentlevels).

1 Enterprise Resource Planning

2 In accordance with the provisions set out in govern-ment decree No. 2118/2006 (VI. 30.) as amended bygovernment decree No. 2255/2006. (XII. 25.)

3 The IKM module in the KGR terminology

4 On-line Analytical Processing

NOTES

PUBLIC FINANCES – Taxation and the tax system

645

E

Zoltán Pitti

The operational efficiency of the fiscal system in terms of key tax and contributionliabilities

Experts often point out that Hungary has a dis-proportionate distribution of tax and contribu-tion burdens, slowing performance, and, at thesame time, an inefficient fiscal system.. Theseopinions, however, are basically subjective innature, supported by only a limited number ofsound arguments. The author (the former presi-dent of the Hungarian Tax and FinancialControl Administration [APEH] and researcherat CORVINUS University) makes an attemptto compare theoretically possible and actuallyrealised tax and contribution revenues and toexplore the phenomena that influence the degreeof differences. The editor regards the present studyas a polemical essay and is glad to give an oppor-tunity to set forth opinions other than the author's.

In Hungary, experts participating in profes-sional debates pay increasing attention to thechanges of total taxation and the study of thestructural composition of the related burden.Representatives of the business sector haveemphasised the volume of tax and contribu-tion liabilities, unpredictable changes and thegrowth of administrative burdens, whileemployee representative bodies and sociologistshave protested against the disproportionatedistribution of tax and contribution burdens.Both sides agree that the fiscal system fails to

function in the right direction and at a properdegree.

The present study has as its subject the lattersubject. Completeness check – an internation-ally applied method – is used to make attemptsto explore the level of efficiency of the Hungarianfiscal system on the basis of macroeconomicdata and to determine those factors that hinderefficiency. The main point of the completenesscheck is that it compares the corresponding dataof the national accounts (kept by the CentralStatistical Office [KSH] and serving as the basisfor GDP calculation) to the actual revenues ofmajor tax categories – that is, the assessment ismade not on a cash-flow, rather than a profit/lossbasis. The survey deals with the functioning ofvalue added tax, income tax, corporate taxschemes, and of the system of social contribu-tion payments; however, as experience hasshown, the same method can be applied toother tax categories, as well. It is only in themost inevitable cases that the completenesscheck of the period from 2001 to 2007 dealswith the annual technical changes of equal fis-cal treatment rules; our attention is focussedon the assessment of the results that can bedetected at a macroeconomic level, as well asthat of lost performance.


646

A COMPLETENESS CHECK OF VALUEADDED TAX

In terms of the functioning of the fiscal sys-tem, a most important issue is that of the oper-ational efficiency of the VAT tax category,which makes up almost two-thirds of the taxesrelated to business turnover (consumption).On the average of the period from 2001 to2007, the VAT balance (net revenue) of theamount to be paid to the budget on the basis ofbusiness turnover and the amount to bededuced as production related spending (repre-senting almost one-third of the tax and contri-bution revenues) was 8.0–8.2 percent of theannual GDP; that is, the functioning of theVAT tax category reflects the changes of eco-nomic performance and of final consumption,and essentially constitutes the secure basis ofstate revenues.

The basis of the completeness check of theVAT tax category is an analysis of the grossnational product in terms of major factors.Simplified evaluations, for the sake of interna-tional comparability, compare the net VAT rev-enue realised by the central budget to the valueof final consumption. In-depth analyses use thedetailed data of the National Accounts andthus display a more complex approach to thedetermination of the basis of VAT assessmentfalling under the scope of VAT. Therefore, theannual final consumption data should beadjusted by the value of the benefits in kindallocated to households; the value of gross cap-ital formation should be adjusted by the fixedcapital formation of the governmental sector(not eligible for VAT deduction) and of house-holds; and when determining the total basis ofVAT assessment, the balance of foreign tradeturnover should be taken into considerationeither as an augmenting or a reductive factor.

The theoretically possible amount of VATrevenues (calculated VAT) can be calculated bymultiplying the basis of VAT assessment

(summed up as described above) by the aver-age VAT rate. Taking into consideration thefact that VAT rates and the content scope ofthe products and services falling into thescope of various rates underwent severalchanges in the period from 2001 to 2007 (thenormal rate of 25% was reduced to 20%, thenthe preferential rate of 15% was abolished anda universal VAT rate of 20% was introduced),it is reasonable to calculate the average VATrate as weighed according to consumption(See Table 1).

It is evident from the survey of the com-pleteness check data relating to the period from2001 to 2007 that due to changes in legislation,the relatively dynamic growth of the theoreticalbasis of VAT assessment is due for the most partto the governmental sector (“not liable todeduction”), the investment allocations of thehousehold sector and the final consumption ofhouseholds, while the growth of in kind bene-fits, the decrease of weighted VAT rates and thedeficit of foreign trade turnover (see years2006–2007) reduced theoretically realisableVAT revenues.1

One of the conclusions of the completenesscheck is that in the long run the value of theo-retically realisable VAT revenues increasesfaster than the value of actually realised VATrevenues (hence the major difference betweenthe theoretically performable and actuallyrealised VAT revenues, at above 1500 billionHUF in the years 2006–2007); another impor-tant conclusion, however, is that revenue effi-ciency fluctuates between very diverse extremevalues. This phenomenon is a result of complexcauses; among others, the deficiencies of regu-lation, hectic movements of economic per-formance, the deterioration of the taxpayerbasis and of law abiding behaviour, and, last butnot least, the fact that control mechanismsimprove slower than desirable, all contribute tothis outcome. The factors to be noted are asfollows:


647

The difference that can be traced back to reg-ulation:

• the limit of values of taxpayer exemptionand the great number of those who exer-cise this right (in the EU, the exemptionlimit is 10,000 EUR while in Hungary it isHUF 4 or 6 million);

• classification on the basis of exempt activ-ity (if compared to the previous years, thenumber of those involved is definitelysmaller yet still greater than the EU aver-age);

• a great number of those activity rangeswhich do not fall under the scope of the

obligation to issue an invoice and into thescope of VAT application (agrarian pri-mary producers);

• the growth of the number of enterprisesfalling under the scope of simplified entre-preneurial tax (EVA) and a particularaccounting mechanism that does not breakdown the revenues generated on the basisof the general tax rate of 25% (formerly:15%) into tax categories.The difference that can be traced back to the

structural features of the Hungarian economy:• a dynamic expansion of businesses spe-

cialised in the further processing of

Table 1

THE COMPLETENESS CHECK OF THE VAT LIABILITY OF THE TURNOVER OF PRODUCTS AND SERVICES

(billion HUF)

2001 2002 2003 2004 2005 2006 2007*Total value of final consumption 11,097.5 12,904.6 14,904.8 15,971.9 17,082.8 18,173.9 18,956.9

of which: final consumption of households 9,583.8 11,077.8 12,816.0 13,903.8 14,910.7 15,744.4 16,503.3

of which: benefits in kind** 1,717.4 2,104.9 2,500.0 2,568.6 2,785.9 2,996.3 2,978.4

community consumption 1,513.7 1,826.7 2,088.8 2,068.1 2,172.1 2,429.5 2,453.6

Total value of purchased consumption 9,380.2 10,799.6 12,404.8 13,403.3 14,296.8 15,177.6 15,978.5

Total gross capital formation 3,980.9 4,224.2 4,557.6 5,398.1 5,198.8 5,499.7 5,844.1

of which: gross fixed capital formation 3,493.0 3,916.9 4,156.0 4,650.7 5,016.7 5,169.5 5,304.5

of which: governmental sector 563.3 815.7 653.0 733.7 873.0 1,049.9 1,179.0

households 860.1 993.8 1,114.1 1,304.2 1,203.3 1,091.9 1,175.3

Capital formation serving as a basis

of VAT assessment 1,423.3 1,809.5 1,767.1 2,157.1 2,198.8 2,247.0 2,540.0

Balance of foreign trade turnover –228.6 –388.4 –811.7 –652.8 –239.2 121.7 572.9

of which: export sales 10,803.4 10,843.5 11,515.3 13,166.9 14,606.2 18,505.6 20,287.2

import procurement 11,032.0 11,231.8 12,327.0 13,819.7 14,845.4 18,383.9 19,714.4

Total value of theoretical basis

of VAT assessment 10,574.9 12,220.8 13,360.2 14,907.6 16,256.5 17,546.3 19,091.4

Average VAT rate (Weighted average) 20.22 19.11 19.22 20.35 21.96 18.71 18.55

Theoretically realisable VAT revenue 2,138.2 2,335.4 2,567.8 3,033.7 3,569.9 3,282.9 3,541.5

VAT revenue according to the National Account 1,230.2 1,340.9 1,539.9 1,812.5 1,829.7 1,769.9 1,978.4

Fulfilment rate of VAT liability, % 57.5 57.4 60.0 59.7 51.3 53.9 55.9

*preliminary data

** As opposed to the practice of previous years - among market economy conditions - the final consumption does not need to be adjusted by thedata of households and community consumption (on the basis of general features this category is also liable to VAT); however, the balance of inkind benefits and foreign trade turnover should be regarded as a correction item.

Source: the annual data of the National Accounts (KSH) and the “APEH Világa” annual report


648

imported primary materials and semi-fin-ished products, which results in the factthe on the budget level the balance of theVAT generated on the basis of imports andthe VAT claimed to be refunded on thebasis of exports, is invariably and progres-sively negative;

• the atomised nature of economic opera-tors (98% of enterprises are categorised asmicro or small enterprises);

• enterprises that fall into the same propri-etor category often employ the practice of“carrousel invoicing”, which distorts bothVAT results and corporate performance. Due to other conditions:

• selling without invoices, which results inthe fact that products and services trade aswell as VAT liability falls outside the scopeof business turnover registered in the mar-ket;

• the great number of instances of unjusti-fied VAT deduction and VAT refundclaims – “popular methods” include theissuing of fictitious invoices or accountingpersonal consumption as entrepreneurialexpenses;

• when compared to the growth of the num-ber of enterprises and market transactions,control capacity displays insufficientgrowth;

• instead of an analysis of macroeconomicprocesses and an evaluation of tax returninformation, the returns are summed upmechanically.

Theoretically, the VAT system could func-tion more efficiently, and, among the presentbudgetary circumstances and in order toimprove the fairness of fiscal treatment, thiswould be absolutely indispensable. Thisrequires, among others, a re-consideration of theeconomic development strategy (What kind offuture do we envisage for the processing activ-ities related to imported primary materials andsemi-finished products in Hungary? How long

will we build the maintenance of our competi-tiveness upon the mistaken concept of cheaplabour supply?). In addition, the modernisationof regulations and, at the same time, theimprovement of the transparency of VAT sub-jects and of the VAT accounting process mustnot be postponed. It is time to shift from datamanagement to an analysis of information andto a deeper examination of economic correla-tions.

THE TAXATION OF PERSONAL INCOME;THE OPERATIONAL EFFICIENCY OF THEINCOME TAX SYSTEM

The system of income taxation plays a directrole in the tendencies of the revenues of thegovernmental sector, indirectly affects thegainful employment of natural persons (accel-erates or slows down performance and deter-mines labour costs), while the distribution ofburdens among the major forms of gainfulemployment and major income owners is a sig-nificant factor of the enforcement of the prin-ciple of social fairness. As the data of theNational Accounts show, in the period from2001 to 2007 the GDP-proportionate value ofwages and salaries showed a tendency of growth,while the index of actual income tax payments(calculated in GDP ratio) decreased from 7.2%to 6.3%.

The completeness check of income taxation(see Table 2) offers some interesting insights.It is well worth considering the fact the wagesand salaries data of the National Accounts forthe period 2001 to 2007 show a growth moredynamic than that of the incomes subject to accu-mulation, registered on the basis of annualincome tax returns. According to the data of2006–2007, the difference between the absolutevalues is 1500–1600 billion HUF; however,given that in conformity with the effectiverules incomes subject to accumulation include


649

income items from taxation, the actual differ-ence is even greater. Our research showed thatthis difference – which makes up almost one-fifth– is a result of the fact that the “wages andsalaries” data of the National Account show agrowth that is faster than the actual one, a con-sequence of the lower than actual willingnesson taxpayers' part to include incomes subject toaccumulation in their tax returns.

A significant element of the completenesscheck was the breakdown of the wages andsalaries data of the National Accounts accord-ing to income brackets and the annual determi-nation of the average income tax rate. In thisstudy, the income distribution processed by thetax authority (APEH) on the basis of annualpersonal income tax returns was considered asthe basis of reference,2 and the average tax ratewas determined as a result of weighing byincomes under various income brackets.

In the period from 2001 to 2007, the ratio ofrealisable and realised tax revenues fluctuatedbetween diverse extreme values. On the basis ofan analysis of recent years' practice, the majorreasons for the differences calculated on thebasis of modelling and displayed in the tax preparations can be determined asfollows:


• The highest income decile is almost 8times bigger than the lowest one, yet theeffective regulations ignore different eco-nomic capacities;

• the enforcement of the tax exemption ofthe minimum wage (one-fifth of employ-ees are registered as receiving a minimumwage);

• the number of enterprises falling into thescope of simplified entrepreneurial tax

Table 2

THEORETICALLY REALISABLE INCOME TAX REVENUES CALCULATED ON THE BASIS OF GDP FACTORS AND REALISED INCOME TAX REVENUES

(current price, billion HUF)

2001 2002 2003 2004 2005 2006 2007*Gross national product (market price) 14,849.8 16,740.4 18,650.7 20,717.1 22,042.5 23,795.3 25,373.9

Gross added value (basic price) 13,077.5 14,807.6 15,944.7 17,654.4 18,879.0 20,540.1 21,938.4

Employees' income 6,798.7 7,710.1 8,591.1 9,506.8 10,260.7 10,944.6 11,802.9

of which: value of wages and salaries 5,161.5 5,881.0 6,640.0 7,419.3 7,979.3 8,541.3 9,146.4

Wages and salaries in the ratio of gross added

value calculated at market price (%) 34.8 35.1 35.6 35.8 36.2 35.9 36.0

Total value of incomes subject to accumulation

in income tax returns in the reference year 4,424.9 4,935.5 5,507.4 5,853.4 6,390.5 7,000.9 7,736.0

Average income tax rate weighted by size

of income (%) 35.04 35.73 35.28 32.25 31.49 30.15 30.03

Theoretically calculated tax payment liabilities 1,808.7 2,101.3 2,342.6 2,392.7 2,513.0 2,575.6 2,746.7

Value of actual tax payments 1,142.9 1,294.4 1,325.3 1,363.3 1,449.7 1,599.0 1,794.4

of which:Incomes subject to separate taxation 80.4 90.0 95.3 103.9 125.9 155.2 192.8

Value of corrected income tax payments 1,062.5 1,204.4 1,230.0 1,259.4 1,323.8 1,443.8 1,601.6

Fulfilment ratio of income tax payment

liabilities 58.7 57.3 52.5 52.6 52.7 56.1 58.3

* preliminary data

Source: the annual data of Hungary's National Accounts (KSH), the non-financial accounts of the government and the “APEH Világa” annual flashreport.


650

(EVA) and a particular accounting mecha-nism that does not break down the rev-enues generated on the basis of the gener-al tax rate of 25% (formerly: 15%) into taxcategories.

• agriculture was taken out of the scope of normative regulation (primary produ-cers).The difference that can be traced back to the

structural features of the Hungarian economy:• incomes realised in the informal economy

are accounted for on the basis of estima-tions;

• the low level of economic activity and theexpansion of non-registered employment(according to the 2006 data, out of7,720,000 economically active-aged per-sons only 3,930,000 persons are actuallyemployed, out of whom only 3,300,000persons made tax returns related toincome resulting from employment);

• micro and small enterprises disburse own-ers' income not through “entrepreneurialhandouts” (which are subject to incometaxation) but by way of dividends and thusreduce their income tax liabilities andsocial contribution liabilities.Due to other conditions:

• the expansion of the hidden economy(extensive use of “wage saving methods);

• the defencelessness of employees (feignedcontracts remain an issue);

• a material and cultural differentiation ofthe society, which offers variegated oppor-tunities to find employment that adopts tothe changing market demands (regionsspecialised on agricultural activity nowcannot offer jobs).

A seriously disproportionate feature of theincome-proportional fiscal system is thatalmost 90 percent of stated incomes comes fromemployment while capital-derived incomes – incontrast to the actual situation – represent onlya 10% ratio. As for incomes from work, one-

fifth of taxable persons pay taxes on the basisof zero income or minimum wage income(thus hardly making up 7.5 percent of theincome tax paid); those paying taxes on the basisof the average income represent 68% but carrymore than 72% of the tax burden; income own-ers with incomes significantly above the aver-age bear just one-fifth of the total of incometax obligations. To sum up, the analysis ofincome tax data also give evidence that thosewith average income carry a larger burden thanthe average earner (therefore, there is a strongmotivation to remove incomes from legal chan-nels), while persons with incomes higher thanthe average participate in the financing of pub-lic expenditure at a degree lower than thatwhich is allowed by their economic capacity.3

TAX OBLIGATIONS BASED ON ENTERPRISE PROFITS

As a result of the highly variegated entrepre-neurial types of the Hungarian business sector,the profit-proportionate burden sharing prac-tice of economic operators can be evaluatedexclusively in the case of those enterprises thatfunction as corporate bodies. Even in this nar-rowed-down field, problems are posed by thegrowing gap between registered and actuallyfunctioning enterprises, the fact that enterpris-es fluctuate between various corporate forma-tions (joint stock companies [rt.] and limitedliability companies [kft.], unlimited partner-ships [bt.] and simplified entrepreneurial tax[eva]) and that tax rules are specified on thebasis of enterprise types.

According to the economic theory, the drivebehind the operation of the business sector isprofit and the augmentation of entrepreneurialproperty. In Hungary, the taxation of corporateenterprises is fundamentally based on the posi-tive results of enterprises. A basic data of thecompleteness check is the gross operating sur-


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plus of the domestic product (GDP) calculatedon an income basis; this is compared to thetotal value of realised entrepreneurial taxes.The result of the survey depends on several fac-tors: the changes of entrepreneurial profit,exemption and allowance conditions, thedegree of profit centralisation and the willing-ness to pay taxes. (See Table 3)

After a transitional deterioration, the ratio oftheoretically realisable tax revenues calculatedon the basis of GDP factors and realised taxrevenues shows an improving tendency; albeitthe improvement of total performance is alsocontributed to by the increase of tax burdens(4% surtax) and a significant restriction ofallowance titles. The improvement of efficien-cy was also facilitated by a decrease of the num-ber of enterprises that showed deficit; never-theless, it is slowed down by the tax avoidanceof “paper” enterprises, in other words, anabsolute and a relative deterioration of the will-ingness to pay taxes.

The tendency displayed by the differencebetween corporate tax revenues calculated onthe basis of modelling and actual corporate taxrevenues is positive yet the amount of the rev-

enues which are “lost” from the perspective of thebudget is still significant. Taking into considera-tion the practice of recent years, the phenome-non can be attributed to the following facts.


• the upward valuation of the items thatincrease and decrease earnings before taxand an unfavourable change of the balance(cca. –2500 billion in 2007);

• an incentive to split enterprises (under agiven limit of value the opportunity of a10% profit tax is offered);

• the relatively high level of the previouslygranted tax allowances (secondarily, itsdisproportionate distribution);

• a growing mass of losses carried over fromprevious years, and the annual “setting-off ” effectuating the decrease of earningsbefore tax (in 2007 318.2 billion HUF);

• the low efficiency of support policies andits “no consequence” practice.The difference that can be traced back to the

structural features of the Hungarian economy:• the extension of the informal economy;• the decrease of the specific capitalisation

Table 3

THEORETICALLY REALISABLE AND REALISED TAX REVENUES BASED ON ENTREPRENEURIAL PROFIT

(at current prices, billion HUF)

2001 2002 2003 2004 2005 2006 20071. Gross national product (GDP) 14,849.8 16,740.4 18 650.7 20,717.1 22,042.5 23,795.3 25,373.9

2. Gross added value (basic price) 13,077.5 14,807.6 15,944.7 17,654.4 18,879.0 20,540.1 21,938.4

3. Gross operating surplus 6,303.0 7,144.0 7,399.1 8,251.9 8,737.7 9,738.4 10,614.9

4. of which: operating surplus of businesses 3,166.8 3,815.3 3,967.5 4,401.9 4,658.5 5,465.9 5,997.4

of which: corporate enterprises 2,363.7 2,744.6 3,356.7 3,503.7 4,240.1 4,583.6 4,960.6

5. Corporate tax liabilities (%)* 18.0 18.0 18.0 16.0 16.0 17.0 20.0

6. Calculated tax payment liability (4*5) 570.0 686.8 714.2 704.3 745.4 929.2 1,199.5

7. Actual profit tax payments 351.9 396.6 413.7 438.0 465.6 596.2 835.4

8. of which: performed by corporations 282.9 308.9 351.4 336.1 367.6 414.3 606.8

9. Fulfilment ratio of profit tax obligations (%) 61.7 57.7 57.9 62.2 62.5 64.2 69.7

* augmented by the solidarity tax and the surtax of financial institutions

Source: Hungary's National Accounts (KSH), “APEH Világa” annual flash report (APEH-SZTADI)


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of enterprises (undercapitalisation) andthe high cost of loan capital (the averageinterest is higher than the profit rate ofcapital investments);

• enterprises have shifted from fields thatused to offer high income and reasonableresults (processing industry) to fields withlower efficiency (service);

• the atomisation of economic operators andthe consequences of ignoring economiesof scale;

• an increasing level of circular indebtednessand a consequent deterioration of results(construction industry, trade, agriculture).Due to other conditions:

• the high annual rate of replaced enterpris-es and the fact that enterprises with built-up debt to the central budget are liquidat-ed with no consequences;

• the phenomenon of selling without invoic-es (well-known in the field of VAT)reduces the basis of VAT assessment and,at the same time, accounting for fictitiousinvoices as expenditure decreases theincomes reported by the enterprises;

• the method of saving wages – i.e. substi-tuting staff costs by other expenditure ele-ments – brings about a dynamic increase ofother expenses and a further decrease ofthe basis of tax assessment.

The practice of corporate tax policy isshaped by contradictory influences. From abudgetary point of view, incomes should followthe improvement of performance, yet theimportance of the acquisition of additionalresources and the intensification of the interna-tional tax competition (the demand for theimprovement of capital attraction and capitalretention abilities) calls for a reduction of busi-ness-related withdrawals.4 Furthermore, theEU has initiated a community-level unificationof the determination of the basis for the assess-ment of the corporate tax base (with a contentnarrower than now).

The reliability of the efficiency index – cal-culated from the results of entrepreneurialactivity – is deteriorated by the fact that in theGDP calculation the performance of the informaleconomy is undervalued, and thus the value ofgross operating surplus (basis of reference) isby cca. 23–25% lower than the actual level. Asa result, the “average” fulfilment ratio (between67% and 69%), compared to the “official” data,is nothing more but a result of a calculation –the real level is significantly lower.

SOCIAL CONTRIBUTIONS (EMPLOYERS'AND EMPLOYEES' OBLIGATIONS)

Among market economy conditions, the socialresponsibility shouldered by the state, the rules ofcontribution liabilities and the changes of contri-bution payment discipline play a paramount role.It is a positive change that by linking eligibilityfor services to the fulfilment of contributionliabilities – and as a result of the developmentof IT systems – the willingness to pay contri-butions has visibly improved since 2007. (SeeTable 4)

As a basis of measuring the efficiency of thecontribution system, we use the wage andsalary data of the gross domestic product(GDP) calculated on the basis of income5,which then is compared to the volume ofrealised social contributions – irrespective ofwhether the payer is an employer, an employeeor a self-employed (self-insured) natural per-son.

The completeness check carried out on thebasis of official statistical data, if compared tothe VAT revenues, shows a relatively acceptableresult; however, the reliability of the calcula-tion is brought into question by the fact thatcca. 450,000–500,000 persons “eligible forsocial insurance service” are still not present inthe contribution payer system. Other problem-atic issues are raised by the fact that a relative-


653

ly large number of subjects pay social contribu-tions not on the basis their actual income (cf.750,000–800,000 employees are registered asreceiving a minimum wage) and that there isalso a large number of people eligible for theservice even if no one pays their contribution.6

As a consequence of the above-mentionedfacts, the social insurance funds obtain 550–600billion HUF less than the revenues they are eligi-ble to.


• the maintenance of the contributionexemption of certain fields violates sectorneutrality (agriculture)7;

• the eligibility for services and the fulfil-ment of contribution payment liabilitieshave long been independent of each other;even today there is but a partial connectionbetween the two;

• since 1998, the revenues of social securityhave been continuously distorted by aredistribution of contributions to theadvantage of private pension funds, whilethe effects that decrease the expenditurecommitment of the pension fund will notbe perceptible until 2020;

• capital-derived income (dividend) hasbecome a basis for contribution (healthcontribution [EHO]) only recently and toa limited degree.The difference that can be traced back to the

structural features of the Hungarian economy:• employers and employees have interests

that mutually strengthen each other to beinvolved in undeclared employment and toapply methods that save wages – the for-mer does so in order to get exemptionfrom social contributions, while the latterintends to avoid income tax liabilities and

Table 4

CONTRIBUTION PAYMENT LIABILITIES CALCULATED ON THE BASIS OF THE WAGE AND SALARY COMPONENTS OF ADDED VALUE

(billion HUF)

2001 2002 2003 2004 2005 2006 20071. Gross added value (market price) 14,849.8 16,740.4 18,650.7 20,717.1 22,042.5 23,795.3 25,373.9

1. Gross added value (basic price) 13,077.5 14,807.6 15,944.7 17,654.4 18,879.0 20,540.1 21,938.4

of which: wages and salaries serving as

the basis for social contribution

assessment 5,161.5 5,881.0 6,640.0 7,419.3 7,979.3 8,541.3 9,146,4

basis of contribution assessment

of households and assistance

institutions 438.0 478.5 500.8 581.9 637.5 717.2 765,7

2. Value of incomes subject to contribution

payment 5,599.5 6,359.5 7,140.8 8,001.2 8,616.8 9,258.5 9,912.1

3. Average contribution rate to be paid after

incomes (weighted on the basis of earnings) (%) 44.2 43.6 41.9 40.6 43.1 43.1 44.5

4. Performable contribution according

to modelling 2,475.0 2,772.7 2,992.0 3,248.5 3,713.8 3990.4 4,410.9

5. Total value of actually performed social

contributions (KSH–Ministry of Finance) 1,961.3 2,202.5 2,368.6 2,538.7 2,760.0 2974.9 3,454.9

6. Fulfilment ratio of contribution payment, (%) 79.2 79.4 79.2 78.1 74.3 74.6 78.3

Source: Hungary's National Accounts (KSH), Magyar Statisztikai Évkönyv [“Statistical Yearbook of Hungary”] (KSH), annual flash report (APEH-SZTADI)


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get exemption from social contributions;• in spite of the economic model shift and in

contrast to international practice, enter-prises continue to pay the majority of socialcontributions (employers' rate is 29% whilethe liability of employees was increased to15.5% as late as in 2007), yet the process ofburden redistribution is significantlyslowed down by employees' traditionallylow income and by the fact that theincome reform failed to be introduced.Due to other conditions:

• a material and cultural differentiation ofthe society, which offers different oppor-tunities to find employment that adapts tochanging market demands;

• the constant modifications of social insur-ance rules and the elusive communicationof the content of the service one is eligibleto in return for contribution payment havea harmful effect on payers' discipline.

A future increase of contribution revenues maybe brought about by a growth of economicactivity (employment), the introduction of apersonalised records system, the concentrationof enterprises and the strengthening of control.

On the other hand, the willingness to pay con-tributions may be further weakened by the con-stantly growing amount of contributions to bepaid, the elusive communication of service con-tents and – besides the increasing contributions– the extension of the so-called “created” feeliabilities (consultancy fee, bed fee, etc.)

ALL IN ALL, the difference between the theo-retically realisable and actually realised tax rev-enues (and the differentiated changes in termsof tax categories) is a consequence of the inter-play of several conditions that decrease efficiency.Yet it can also be reasonably stated that theoperational efficiency of the fiscal system andthe conditions that influence efficiency (alongwith legislative changes) are going to have along-term decisive impact on the operation ofthe governmental sector and the business sec-tor alike, and, above all, on the change in thepopulation's quality of life. It would be positiveif decision makers paid attention to this factand considered the saying often quoted in liter-ature on the subject: “That which is not meas-ured either grows worse or makes somethingworse.”

1 This is basically due to the fact that products and serv-ices resulting from imports (purchases within theCommunity) bring about an import VAT liability, whilethe right of VAT deduction can be exercised in connec-tion with the value of exported products and services(products and services sold within the Community). Inthe case of certain international enterprises, this phe-nomenon reaches such a volume that “as a result of thesetting-off option” they are exempted from the pay-ment of other tax categories, as well.

2 See the processing of VAT preparations in the“APEH Világa” yearbook

3 These ratios refer to the 2005 income tax prepara-tion; once the preparations of year 2006 have beenprocessed, the data should be updated.

4 In 2008 Germany – in order to retain capital and pro-tect employment – started to reduce corporate taxburdens by cca. 10 percentage points; neighbouringcountries also have similar initiatives.

5 On the basis of the data of the National Accountsbroken down into years

6 This is an interesting fact, as after a possible privati-zation of the insurance system (in international prac-tice) it is the budget that is obliged to fulfil contri-bution payment liabilities.

7 Albeit the legislation scenario changed in 2008, theresulting revenue increase is yet to be perceived.

NOTES


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A kormányzat nem pénzügyi számlái 1996–2006,[The Non-financial Accounts of the Government1996–2006] (2008): KSH, Budapest

APEH Világa éves beszámolójelentések [The Worldof APEH. Annual Reports], Adó- és PénzügyiEllenõrzési Hivatal, Budapest

Government finance statistics, EUROSTAT, edition

Magyar Statisztikai Évkönyvek [StatisticalYearbooks of Hungary], KSH, Budapest

Nemzeti Számlák éves adatai [The Annual Data ofthe National Accounts], KSH, Budapest

Taxation trends in the European Union, (2008):EUROSTAT, edition

LITERATURE

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I

Zoltán Lóránt

Local public finance and local taxes

I wish to provide an overview of the role andweight of an increasingly important source ofincome of the nearly 3200 Hungarian localauthorities, i.e. local taxes. Local public financerepresents 12–13 per cent of GDP expenditures,and 23–25 per cent of public finance expenditures.

Regarding income centralisation, the propor-tion of slightly over 2 per cent of local taxes com-pared to the GDP in Hungary is lower than inother countries. However, these taxes are predom-inantly paid by enterprises. Enterprises areobliged to pay corporate income tax and localbusiness tax, the former after their profit, adjustedin accordance with the provisions of the Act onAccounting, the latter after their revenues, which,naturally, affects the competitiveness of enterpris-es. In OECD countries, applying the principle ofequitable contribution to public revenues basedon property, property-type taxes comprise 3–4 percent of the GDP, while in Hungary, together withother property-type contributions to public rev-enues, they remain under 1 per cent.

EUROPEAN OVERVIEW

Legislation regarding the finances of local authori-ties does not fall under Community competence inthe European Union. As a result, the financialregulations concerning local authorities are char-

acterised by differences originating in historicaland national traditions. However, the widelyaccepted common values of local governanceappear in the legislation of all EU MemberStates. These common European values of localgovernance were recorded in a document(“European Charter of Local Self-Government”)adopted by the Council of Europe, which wascomprised of numerous European countriesbesides the fifteen EU Member States. TheCharter was ratified1 by Hungary, too.

Article 9 of the Charter deals with thefinancing of local authorities, and with issues offinance, economy, and financial management.It states that the basis of financing localauthorities is their being entitled to adequatefinancial resources, obviously limited by theindicators of the given national economy. Partat least of the revenues shall derive from localtaxes and charges of which, within the limits ofstatute, local authorities have the power todetermine the rate.

Another central thesis of financing localauthorities is the recognition of the autonomyof their financial management, i.e. of their rela-tive freedom of allocating and spending thefunds collected. Within the framework of thefulfilment of the obligatory tasks of localauthorities, the funds distributed by the statemay entail restrictions on what they can be


657

spent on. To thwart the unnecessary expansionof that trend, it is required that the proportionof earmarked sums, which entail restrictions onwhat they can be spent on, should preferablynot exceed an absolutely necessary extent.

Internationally, we can see that certain EUMember States have a separate act regulating thefinancing of local authorities (United Kingdom,the Netherlands, and Austria). In these coun-tries the Local Authorities Act does not containan in-depth treatment of financing issues. At thesame time, each EU Member State is free todecide the operation of which taxes to entrust tolocal authorities, and what sort of limitations toset for them. Only that there is to be a tax type inthe tax system whose rate, within the limits of thestatute, is determined by local authorities is gener-ally expected. The Hungarian Act on Local Taxes,allowing local authorities considerable latitude,almost unparalleled in Europe in fact, is charac-terised by that latter notion.

The structure of resources of the budgetary rev-enues of local authorities has evolved similarly allover Europe. Accordingly, these three major formsof financing can be found in all Member States:

• supports from the central budget,• “shared” or “transferred” revenues, from

taxes or other payment obligations, and• local authorities' own revenues.However, among the Member States, there is

considerable divergence with regard to the sta-tus of the sources of revenues within the nation-al economy and the system of public finance,their share in these, and the relative weight andproportion of the different financing solutions.

The significance of the sources of revenues avail-able for local authorities within the national econ-omy and public finance is best indicated by theirshare from the annual GDP of the given country.In this respect, we find considerable differencesbetween the states opting for the NorthernEuropean model of local governance, endowedwith a wide scope of responsibility (where thesphere of local self-governance is deemed the

largest provider of public services), and thoseimplementing the Southern European model oflocal governance, relying on the sphere of localself-governance regarding public services to alesser degree. The former group is comprised ofcountries where the share of the sphere of localself-governance from the GDP exceeds 10 percent; for instance the Scandinavian countries(nearly 30 per cent in Sweden, and as high as 20per cent in Denmark), Finland (approx. 18 percent) or the Netherlands (nearly 20 per cent).By contrast, the model of local governancewhich has evolved in the Southern EuropeanMember States is characterised by a GDP shareof under 10 per cent. Among these countries,the share of the sphere of local self-governanceis around 2–3 per cent in Greece, 5 per cent inPortugal and Spain, 7 per cent in Italy, and itdoes not exceed 9 per cent in France, either.(The Hungarian local authorities with theirshare of over 12 per cent are somewherebetween the two models. Their structures andauthorities are characterised by midway solu-tions relying on both models.)

Examining proportions within the structure ofresources available for local authorities, it hasbeen found that as far as the support receivedfrom the state is concerned, the proportions ofthe sums awarded

• on a normative basis (normative supportreceived from the state) and on a differentbasis (non-normative support receivedfrom the state – with quite wide-scaleavailability and titles), and

• with restrictions on what they can be spenton (earmarked sums) and without suchrestrictions (supports received from thestate to be utilised freely) are far frominsignificant.

Shared or transferred revenues represent a shareof local authorities – of a determined extent – inthe payment obligations centrally stipulated forpublic finance (i.e. those uniformly regulatedwithin the whole country). Typically, these are


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taxes; however, there may exist payment obliga-tions with different names (e.g. “duty” or “con-tribution”). The terms “shared” and “trans-ferred” refer to what characterises the route ofthe public revenue in question – in the case of theformer, it is the local authorities that levy the taxand “share” it with the central budget, while inthe case of the latter, it is the state that “trans-fers” a statutorily determined part of a central taxrevenue to local authorities.

The diverse group of local authorities' ownrevenues is typically comprised of the followingfinancial resources and titles:

• local taxes (tax type set by local authori-ties, i.e. unilateral payment obligation),

• local charges (charge type set by localauthorities, i.e. payment obligation due forlocal services), revenues from fines,

• revenues deriving from properties of localauthorities (e.g. privatisation revenues,concession fees, rental fees, dividends,interests, capital gains),

• funds received, and• loan revenues (bank loans, revenues from

bond issues).The financial regulatory solutions regarding

the systems of local governance of the MemberStates differentiate between support-basedfinancing, and tax-based financing. In the formercase, over 50 per cent of the funds available forlocal authorities is comprised of state budgetsupports (e.g. in the Netherlands and GreatBritain). In the latter case, it is taxes (i.e. centraland local taxes) that play a decisive part. Forinstance, such tax-based financing is adopted inDenmark and Sweden.

THE FINANCIAL AND LEGAL ENVIRON-MENT OF LOCAL TAXES IN HUNGARY

In order to create the economic basis of localgovernance and further expand it, the Hungariantax system has had local taxes for nearly 20 years.

Upon the coming into effect of Act C./1990 onLocal Taxes, it became a basic constitutionalright of municipalities to issue decrees on theintroduction of various local taxes (such as taxon buildings, land parcel tax, communal taxpayable by private individuals, communal taxpayable by entrepreneurs, tourism tax, andlocal business tax).

Pursuant to the Act on Local Taxes, the rep-resentative bodies of municipalities2 have thecompetence and authority

• to determine the date of the introductionand the duration of local taxes within theirarea of competence, and to make detailedregulations on local taxation,

• to set the tax rates to be introduced, takinginto consideration certain local character-istics, the requirements of the financialmanagement of the municipality, the bur-denability of the taxpaying entities, andthe upper limits of tax rates determinedstatutorily (they may also extend the regu-lations regarding tax exemptions andallowances at their discretion),

• to supervise the levying of taxes throughcalling for notary's reports, and to informthe inhabitants on the local tax revenuesannually.

It also needs to be highlighted that, pursuantto the Act on Local Authorities, the adminis-trative supervision of local authorities is under-taken by the Regional Public AdministrationOffices. It is their task to assess whether thedecisions of local authorities (including localtax regulations) are in compliance with the law.In addition, regarding the different bodies oflocal authorities acting as authorities of publicadministration and undertaking tasks of publicadministration, the Public AdministrationOffices are entitled

• to call professional co-ordinatory meet-ings, and

• to conduct audits at town halls, offices ofdistrict notaries, offices of county assem-


659

blies, administrative associations of settle-ments, and the Municipality of Budapestpursuant to their supervisory authority.

In addition to such audits, they offer profes-sional assistance highlighting changes in the leg-islation and calling attention to infringementsof the law experienced in local legislation in cir-culars and at notary's meetings. That latterforum is especially important because the per-formance of the tasks relating to local taxationis indeed de-centralised, delivered within theorganisational structure of each settlement,which sometimes entails considerable differ-ences in terms of personal and material stan-dards and conditions. It is worth noting thatdue to the compulsion of taxation, the repre-sentatives of the settlements concerned have toface both the attitudinal factors negativelyaffecting the inhabitants and the “given” eco-nomic opportunities of the region the latterinteracting with the economic and social cir-cumstances of the micro-region.

Within the area of competence of localauthorities, immovable properties and the relat-ing rights of property value, the employment ofworkforce, the performance of business activi-ties, and being provided with accommodationnot as an inhabitant permanently dwelling in thesettlement are deemed taxable. Consequently,local authorities may introduce land parcel taxand tax on buildings, local business tax, commu-nal tax payable by enterprises and private indi-viduals, and tourism tax. Naturally, actual taxpayment obligation may only arise from decreesissued by local authorities, whose taxationlicence relates to introducing and modifying dif-ferent taxes, as well as setting the tax rates,defining the applicable exemptions andallowances, and setting out the rules of local tax-ation within the limits of the statute. On theother hand, the law prohibits the modificationof the rules relating to a tax already introducedwithin the calendar year, i.e. a mid-year increaseof a tax burden. Another restriction is that tax-

paying entities may only be obliged to pay onetype of tax (either property-type tax or commu-nal tax) on one taxable property.

The Amendment of the Act on Local Taxes,effective as of January 1, 1996, created an oppor-tunity to expand funding for voluntarily under-taken local tasks by diminishing central exemp-tions and allowances, and raising the applicabletax rates, thus, indirectly, by increasing localauthorities' own revenues, which opportunitymunicipalities have opted to take to a larger andlarger extent. Due to the widening range of thepublic tasks to be performed, the decrease of thereal value of budgetary support, and furtherfinancial difficulties, both the number of localauthorities introducing local taxes, and the pro-portion of local tax revenues significantlyincreased after 1996. (The proportion of local taxrevenues within the total revenues grew from 5.7per cent in 1996 to 15 per cent in 2007.) Localtaxes accounted for 0.8 per cent of the GDP in1993, and 2 per cent of the GDP in 2007 whilethe rate of income centralisation also increased asa result of the effects of the measures imple-mented in 2007, which caused an increase of rev-enues and affected central taxes. Table 1 demon-strates changes in local tax revenues.

The EU law harmonisation required the abol-ishment of local business tax exemptions andallowances as of December 31, 2007. Thus, sinceJanuary 1, 2008, only enterprises whose taxbase does not exceed 2.5 million HUF mayreceive tax exemption or tax allowances –under conditions set out in a decree issued bythe local authority. The abolishment ofallowances and exemptions has significantlyincreased the tax burden of enterprises, whichhas led several local authorities (e.g. those ofKecskemét and Debrecen) to decide to gradu-ally decrease the local business tax rate. Suchsteps may induce a tax competition amonglocal authorities wishing to attract enterprises.

Pursuant to Article 2 (4) of Act XXXVI-II./1989 on the State Audit Office of


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Hungary it is the task of the State Audit Officeto supervise the taxation-related activities oflocal authorities. The State Audit Office hasaudited3 such activities of local authoritiestwice: first in 1996, then in 2001. Below, Iwish to review the weight and role of localtaxes in the financial management of localauthorities based on the preliminary studydrawn up to summarise the findings and serveas a basis for a new thematic audit.

TAX POLICY AND THE MAJOR MACRO-ECONOMIC IMPLICATIONS OF LOCALTAXATION

Income centralisation with questionmarks

Professionally speaking, prior to any analysis itis necessary to ask whether it is possible toincrease the current extent of income centrali-sation in public finance. If we merely considerthe unexploited opportunities, the state budgetdeficit, the legal and illegal evasion of con-tributing to public revenues, and the fundsrequirements of public expenditures, theanswer is, unambiguously, yes. However, if we

emphasise the effect of excessive leviesstrengthening the black economy, the capitalrequirements of SMEs, and last but not least,the decrease of taxpayers' real incomes, thenthe answer is, unambiguously, negative. Today,the Hungarian economy is characterised byoverregulation and overextensive income cen-tralisation: we are compelled to ensure heavyredistribution. The measures of a thoroughlyprepared tax reform implemented with propergradualness ought to serve to establish a stableand predictable system of taxes and contribu-tions, which can be made valid assumptions onfor several years ahead, eradicating the negativeeffects of frequent changes on business calcula-tions, and securing the predictability of the rev-enues of the central budget within the har-monised systems of central and local taxes.

Is it possible to find the right solution?Economically speaking, a reform of publicfinance, references to which have been madefor decades, without its long-term effects everbeing thoroughly considered, as well as themodification of the current, paralysing systemof taxation, and, above all, the long-term, seri-ous reconsideration of the expenditure side ofall four subsystems of public finance4 havebecome “compelling needs” by now.

Table 1

CHANGES IN LOCAL TAX REVENUES (NATIONWIDE FIGURES)(million HUF)

Name of tax 1995, actual Proportion, % 2007. actual Proportion, %

Tax on buildings 4,145 8.9 54,556 10.8

Land parcel tax 813 1.8 6,900 1.3

Communal tax payable by private

individuals 747 1.6 9,069 1.8

Communal tax payable by entrepreneurs 1,075 2.3 1,261 0.2

Tourism tax paid after stays 768 1.7 4,935 1.0

Tourism tax paid after holiday houses 363 0.8 1,412 0.3

Local business tax 38,472 82.9 427,133 84.5

LOCAL TAXES, TOTAL 46,383 100.0 505,266 100.0

Source: Hungarian State Treasury


661

It is necessary to make it clear for the wholesociety which tasks the state is able to undertake toperform and to what extent it is ready to financethem. The same requirement is especiallyimportant regarding the subsystem of publicfinance comprised of local authorities as nowa-days the nearly 3,200 local authorities and the13,000 budgetary institutions directly super-vised by them need to undertake several publictasks as “services” on a daily basis, while theirannual budgetary financial management is notprovided.

It cannot be treated as a piece of macroeco-nomic determinism that the fiscal policy shouldimplement a system of self-provision of an ever-widening scale, extended to the whole popula-tion, while drastically draining incomes.Consequently, in today's changing economicand social setting, it seems necessary todefine the extent and scope of the perform-ance of public tasks, and to make stipulationson their direct or indirect financing in the Acton Public Finance. Or, to put it more simply:

who is going to perform certain public tasksin the long run and how (i.e. drawing on whatresources)? Or, should they fail to be per-formed, what economic and social conse-quences are expected in health care, publiceducation, culture, public administration, oreven public transport, etc.? It is also impor-tant to note that the redefining of classicalpublic tasks has been discussed for years now;on the one hand, there has been a “concise”revision of tasks, usually entailing a decreaseof funding without conducting impact stud-ies, while, on the other hand, there has beenthe continuous collection of the more andmore easy to levy tax forints going on. Chart1 illustrates all that from the point of view ofavailable funds, demonstrating the changes inthe distribution of revenues of local authori-ties.

Appendix 2 illustrates the changes in the realvalue of the revenues and expenditures oflocal authorities, the analysis of which is notan objective of the present study. However, it

Chart 1

DISTRIBUTION OF GFS5 SYSTEM REVENUES OF LOCAL AUTHORITIES (1991–2007)

3,500,000.0

3,000,000.0

2,500,000.0

2,000,000.0

1,500,000.0

1,000,000.0

500,000.0

0.0

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

mill

ion

HUF

All own current revenues All transferred revenuesAll state contributions, supports and aids

All transfers within public financeAll accumulation and capital revenues


662

is necessary to emphatically state that on thelocal level of public finance (where, after all, itshould be necessary to enable 13 thousandbudgetary institutions to perform publictasks) positive changes in the consumer priceindex and the real value index are the prereq-uisite of quality operation, while that group ofinstitutions has not even managed to secure“operational automatism” over nearly twodecades.

In the financial management of local gover-nance, accelerating bond issues have played anincreasingly important part, especially in thelast three years. Local authorities undertook toissue bonds of a value of 4.5 billion HUF in2005, 24.4 billion HUF in 2006, and 180 billionHUF in 2007 (with capital repayment morato-ria of 3–5 years and of terms of 15–18 years onaverage). This process has continued in 2008.The portfolio of the bonds issued has grown bya further 96 billion HUF in the first half of2008. To make sure that an increase of bondissues of such an extent will not cause localinhabitants long term financial difficulties, theywill need to be used in long-term developmentprojects within “Economic Programmes”, andare not to be spent on operational expenses oron financing the repayment of older, lessadvantageous credits.

Let us provide a new basis for the tax system

It is necessary to provide a new basis for the taxsystem,6 hitherto characterised by unpre-dictable changes. It is to be done by devisingand unambiguously determining the long-termmeans to be used to finance the tasks necessi-tated by the reform: what may be the optimumweight of taxes within that framework, howmuch leeway ought to be provided for them,and, naturally, how the relation of central andlocal taxes is to change within the system. It

should be done by drawing the limits of centraltaxes and defining the applicability of potentiallocal taxes in order to avoid “clashes” withinthe tax system or tax accumulation.Regulations may only be successfully adoptedprovided “these two” mutually recognise andcomplement each other. It can be easily under-stood that the stronger central taxation is, theless leeway local taxes will have.

Professionally speaking, another importantexpectation may be that a “shift” in any direc-tion regarding one element of the tax systemalmost inevitably entails the modification of theelements directly not affected by the change.This statement is not only valid regarding cen-tral and local taxes, but also within each “cen-tral regulatory” unit. For instance, if theintroduction of a centrally controlled proper-ty tax is approved of, that in itself makes itnecessary to reconsider the current weightand focus of central taxation. The reason isthat it is hardly conceivable that a property-type tax of a significant range and weightshould leave the current structure of leviesuntouched. Should the level of levies stayunchanged regarding the generation ofincomes, final consumption, and accumula-tion, this lack of change will render the oper-ation of a new type of local tax system impos-sible.

The decision may be well-founded if, firstly,it adopts a system approach towards possiblesolutions, and secondly, it takes into accountthe effects beyond the tax system: in order topromote economic growth, and not less signif-icantly, regarding social issues (the social safetynet). Jointly, these factors make it necessary foreconomic, legal, and not less significantly, soci-ological impact studies of high standard to beconducted. Naturally, it is only possible tomodify local taxes without major political con-flicts if the local authorities concerned demandthe changes, and state how they should beimplemented themselves.


663

Limits to increasing local taxes

Examining the macroeconomic implications ofimposing local taxes, it is necessary to face thefact that the possibility of increasing local taxes islimited by several economic and political circum-stances amplifying each other. The increasinglyharsh economic circumstances call for modera-tion as the representatives making the local taxregulations undergo a rigorous test at themunicipal elections every four years. The taxburden to be borne by potential taxpaying enti-ties (enterprises and private individuals) islargely affected by central taxes, unemploy-ment, the increase of the proportion of theinactive population, and the decrease of realincomes. These require serious consideration,if not regarding the introduction of the indi-vidual local taxes, then when selecting taxpay-ing entities (entrepreneurs and/or inhabitants),setting tax rates, and deciding on allowancesand exemptions.

Finally, the question concerning the volumeof “reserves” within the local tax system cannotbe evaded. Potential reserves are best demon-

strated through the examination of the factualfigures of the payment of the tax on buildingsand of local business tax as these are of a sub-stantial volume. These two tax types are deter-mining factors within the revenue structure, asit is illustrated by Chart 2.

In 2007, revenues from taxes on buildingsamounted to nearly 55 billion HUF, while onlynearly one third of local authorities took theopportunity to introduce that tax type, andamong them, twice as many imposed it on realproperties not used for permanent accommo-dation as on real properties used for permanentaccommodation. Nowadays, flats and houses inrural areas, of a lower value and level of con-veniences, tend to be more likely to be bur-dened by the tax on buildings, while the morevaluable urban flat and house portfolio is hard-ly or not at all affected by it. Regarding thatissue, it is also thought-provoking that slightlyover 10 per cent of all taxes on buildings (i.e.6.5 billion HUF) is paid by private individuals.This in itself, and especially together with localbusiness tax, renders the operation of the taxsystem disproportionate, i.e. a substantial part

Chart 2.

PROPORTION OF LOCAL TAXES, COUNTRYWIDE FIGURES, 2007(total amount: 505 bn HUF)

Source: Hungarian State Treasury

other taxes

tax on buildings

local business tax

84.50%

10.80%

4.70%


664

of local taxes burdens enterprises. As I havementioned above, local government represen-tatives tend to exempt potential voters, or, toput it another way, their decreasingly solventtaxpaying entities from paying local taxes. Still,even in settlements where tax on buildings isimposed, with statutorily stipulated and locallycomplemented allowances, its rate typicallyslightly exceeds half of the maximum impos-able rate. Chart 3 demonstrates reserves in thelocal tax system.

To increase revenues, tax on buildings is asuitable and applicable tool for years to come,offering an estimated annual revenue surplus ofnearly 200 billion HUF even through an appli-cation that fulfils the requirement of fairness ata local level.

Local business tax is applied more widely. In2007, as many as 2705 local authorities didimpose it, thus, practically speaking, the poten-tial tax revenue reserve is smaller than in thecase of tax on buildings, considering the num-ber of local authorities. However, the tax bur-

den amounts to approximately 80–85 per centof the maximum imposable level, so local busi-ness tax reserves may be estimated as approxi-mately 100 billion HUF. Apart from these twotax types, no tax revenue can be expected toprovide significant surplus funds for localauthorities.

THE ROLE OF LOCAL TAXES IN THEFINANCIAL MANAGEMENT OF LOCALAUTHORITIES

Over the past decade, as a result of inflationand economic growth, net turnover, whichforms the basis of the calculation of the taxbase of local business tax, has increased.7 Toboost their budgetary revenues, local authori-ties have been increasing the number of localtax types introduced as well as the tax rates(primarily that of local business tax). Also, thenumber of local authorities that have intro-duced some type of local tax has been growing:

Chart 3

PROPORTION OF LOCAL AUTHORITIES IMPOSING LOCAL TAXES / IMPOSING MAXIMUM TAX RATES, 2008

local business tax tax on buildings tax on land communal tax communal tax payable tourism taxparcels payable by payable by

private individuals entrepreneurs

local authorities imposing localtaxes

local authorities imposing themaximum tax rate


665

1640 local authorities seized the opportunity in1995, 2970 in 2000, and 3114 (98 per cent of alllocal authorities) in 2007.

Over almost two decades, the revenues oflocal authorities deriving from the centralbudget (state supports, contributions, the partof personal income tax “transferred”), as wellas their own revenues and local tax revenueshave been growing continuously. This isdemonstrated by Table 2.

Quantitative growth is clearly reflected inTable 2; however, these amounts, in real value,have failed to keep up with the cost surplusnecessary for the performance of public tasks.The Appendix contains data on the changes ofthe real value of the revenues and expendituresof local authorities (between 1991 and 2007).Consequently, local authorities' own revenues,including local tax revenues, which have slight-ly grown in real value, have had a more andmore significant part in the (compulsory andvoluntary) financing of the performance of thetasks of local authorities, and in ensuring theirfinancial stability. This is demonstrated byChart 4.

Nominally, local tax revenues have beengrowing continuously and dynamically since1996: from an annual 46.4 billion HUF in 1995to 222.8 billion HUF in 2000, and 505.3 billionHUF in 2007. As a natural consequence of thegrowth, their proportion compared to the sub-ject year revenues has changed significantly,increasing from an annual 5.7 per cent in 1995to 13.0 per cent in 2000, and 15 per cent in 2007.

Disproportionateness and regionalinequalities in local tax revenues

Among local taxes, local business tax paid byenterprises is obviously the most significant one.Its proportion has always been high, approxi-mately 85 per cent. The total local business taxlevied showed a 5-fold increase between 1995

and 2000, and a nearly eleven-fold increasebetween 1995 and 2007. During the same peri-od, other local tax types (the total of tax onbuildings, land parcel tax, communal tax, andtourism tax) also showed a manifold increase,but they have a smaller weight owing to theirrates. Due to the local business tax concentra-tion in economically more developed regions,considerable differences have arisen regardingthe tax capacity of different settlements.8

Before 1999, for want of a balancing mecha-nism, the differentiating effect of local businesstax on the financial situation of municipalitieswas profound. (Outstanding settlementsinclude Székesfehérvár, Gyõr, Százhalombatta,and Paks.)

Changes in total revenues in different settle-ment types, including changes in revenuesderiving from budgetary relations and localtaxes, are illustrated by Table 3.

The figures show that on average, villageshad a share of 11 per cent of local tax revenues,while 36 per cent of the whole population livein them. The share of the capital city and thedistricts amounted to nearly 41 per cent of taxrevenues, while the proportion of the inhabi-tants is 18 per cent. Finally, the tax share oftowns and cities is approximately 32 per cent,while the proportion of the inhabitants is 48per cent.

There are considerable differences amongthe per capita local tax revenues in Budapest(the capital city plus the district local govern-ments) and the counties; as well as among dif-ferent settlements. In industrially developedregions (settlements) local tax revenuesaccounted for 40–70 per cent of the budget,representing 20–24 per cent of the financialresources on average, whereas in regions strick-en by high unemployment, struggling with ten-sions deriving from the unfavourable econom-ic situation, at a disadvantage both socially andeconomically, local tax revenues represent amere 6–10 per cent of all revenues.


666

Table 2

REVENUES OF LOCAL AUTHORITIES

Year GFS- Own currnt revenues* Local tax revenue**system percenage local busi- percenage percenage

revenues, billion HUF of local billion HUF ness tax, of local of ownbillion HUF revenues billion HUF revenues revenues

1991 386 81 20.9 9 2 2.3 11.1

1992 502 91 18.1 17 12 3.4 18.7

1993 581 106 18.2 27 22 4.6 25.5

1994 730 126 17.3 34 27 4.7 27.0

1995 813 146 18.0 46 38 5.7 31.5

1996 963 206 21.4 81 66 8.4 39.3

1997 1 168 290 24.8 111 93 9.5 38.3

1998 1 304 339 26.0 146 124 11.2 43.0

1999 1 499 443 29.5 198 171 13.2 44.7

2000 1 656 488 29.5 222 187 13.4 45.5

2001 1 904 560 29.4 267 226 14.0 47.7

2002 2 181 627 28.7 297 253 13.6 47.4

2003 2 501 661 26.4 323 272 12.9 50.3

2004 2 673 748 28.0 367 311 13.7 49.1

2005 2 891 795 26.4 398 334 13.5 51.1

2006 3 053 854 26.3 449 380 13.8 52.5

2007 3 081 914 27.2 505 427 15.0 55.2

* Local authorities' own revenues (revenues from institutional activities including VAT, interest revenues, duties, local taxes, dividends, concession fees, other special revenues. fines)

** Local taxes (local business tax. communal tax payable by private individuals, communal tax payable by entrepreneurs, tourism tax, tax onbuildings, land parcel tax)

Source: Appropriation Accounts of the Republic of Hungary (1991–2007)

Chart 4

GFS SYSTEM REVENUES, OWN REVENUES AND LOCAL TAX REVENUES OF LOCAL AUTHORITIES AT 1991 PRICES

600,000

500,000

400,000

300,000

200,000

100,000

0,0

GSF revenues at 1991 prices

Own current revenues at1991 prices

Local tax revenues at 1991 prices

mill

ion

HUF


667

To illustrate the end values of regional inequali-

ties, in Budapest the per capita local tax revenue

was 123,225 HUF in 2007 (51,673 HUF in

2000), accounting for 24 per cent of the total

revenues (22 per cent in 2000), whereas in

Szabolcs-Szatmár-Bereg county it was 19,885

HUF in 2007 (8,687 HUF per capita in 2000),

accounting for 6 per cent of the total revenues (5

per cent in 2000). As for county (countryside)

averages, in 2007 there was also a nearly four-

fold difference between the lowest (Szabolcs-

Szatmár-Bereg, Nógrád, and Békés counties)

and the highest (Fejér and Komárom-Esztergom

counties) per capita local tax revenues. (The dif-

ference was nearly three-fold in 2000.)

The three-fold difference between Szabolcs-

Szatmár-Bereg county's annual 45 per cent and

Tolna county's 145 per cent compared to the

countrywide average in 2000 is still unchanged

(Tolna county's average is primarily related to

the outstanding data of Paks).

All this clearly demonstrates the dispropor-tionateness within the spatial structure of thecountry, reflected in the revenues of localauthorities, and within those, in the local taxrevenues. One relevant characteristic feature isthe sharp division of a macro-regional scalebetween Transdanubia and Eastern Hungary.The nine Transdanubian counties (with the

exception of Baranya county), have over-the-average values, while in the Eastern region allcounty data is below the average.

Unlike the considerable differences betweenthe capital city and the countryside, andbetween east and west in the macro-regionaland county data, the situation is far more dif-ferentiated in the micro-regions. This isbecause in the case of some micro-regions, cen-tres, and municipalities, the dissolution of animportant tax payer or the closure of the prem-ises of a major business may shatter the localbudget (e.g. in Nyírbátor). Parts of settle-ments' becoming independent undermined thefinancial stability of certain municipalities dueto a loss of local business tax revenues. (Forinstance in 2000, the local tax revenue ofKazincbarcika decreased by 490 million HUFdue to the separation of Berente, and the townreceived an instant ÖNHIKI9 aid of 208.5 mil-lion HUF. At the same time, due to the sub-stantial amount of local business tax, only partof the surplus stayed at the Berente localauthority – based on tax capacity, as in 2001 itwas possible to withdraw 325 million HUFfrom personal income tax.)

Over the past decade, local authorities havealso made continuous attempts to increasetheir own revenues through local tax revenues.Characteristically, they have only moderately

Table 3

DISTRIBUTION OF TOTAL REVENUES

2007 All revenues Share in From that: Share in Local Share inm HUF total (%) state contribution total (%) taxes total (%)

and personal

income tax

Capital city + districts 879,490 26.7 215,372 15.8 209,005 41.4

Cities of county rank 559,621 17.0 236,479 17.5 110,532 21.9

Other cities and towns 787,239 23.8 369,640 27.3 129,885 25.7

Villages 654,053 19.9 409,684 30.3 55,843 11.1

County level local

authorities 413,370 12.6 122,888 9.1 0 0

Total 3,293,773 100 1,354,063 100 505,265 100


668

increased the inhabitants' tax burdens, whereas,regarding the taxes to be paid by enterprises(communal tax payable by enterprises and localbusiness tax), many of them have taken theopportunity to set the statutorily determinedmaximum tax rates.

There is larger divergence in the county figuresregarding per capita average local tax revenuesthan per capita GDP averages, which latter fig-ures reflect economic performance. In the periodexamined, there were smaller differencesamong the figures of per capita GDP growththan in the changes of local tax revenues in thecounty breakdown compiled by the CentralStatistical Office. While the per capita GDPgrowth is of a rather similar extent in the coun-ties, there are significant differences in theincrease of local tax revenues, which is illus-trated by Chart 5.

Due to its weight and role, local business tax

deserves one more thought: the local business tax

revenue amounted to 27 billion HUF in 1994,

124.3 billion HUF in 1998, 187 billion HUF in

2000, and 427 billion HUF in 2007, but its

regional distribution, as it has already been men-

tioned, reflects larger inequalities. In 1998, local

business tax per inhabitant was 28.4 thousand

HUF in the capital city, 14 thousand HUF in

towns and cities, and 3.5 thousand HUF in vil-

lages, while in 2007 the same figures amounted to

108 thousand HUF in the capital city, 40 thou-

sand HUF in towns and cities, and 13 thousand

HUF in villages. The latter data shows that the

capital city has 8 times and towns and cities have

3 times higher values than the village average.

Due to a significant increase in local taxes,especially regarding local business tax, differ-ences of such an extent appeared in the rev-enues of local authorities that, in order to pro-mote equal opportunities, it became necessaryto introduce a system of revenue support with-in resource regulation. In connection with that,the need to put more emphasis on the aid pro-vided for the most underprivileged localauthorities was made prominent in the 1999central budget. For the first time, pursuant to

Figure 5

CHANGES IN PER CAPITA GDP AND PER CAPITA LOCAL TAXES IN THE DIFFERENT COUNTIES (2006/2002)

Changes in GDP Changes in local taxes


669

Article 20 (4) of Act XC./1998 on the 1999Central Budget, if the local business tax capac-ity and the per capita personal income tax cal-culated did not reach a threshold value deter-mined according to settlement type, the per-sonal income tax revenues were to be supple-mented to reach that level. Otherwise, the con-tribution of the state was to be decreased. Atthe beginning, their underprivileged statusentitled 94 per cent of settlements to receive asupplement, and 2.6 per cent were concernedby the decrease. The source of the supplementwas a part of the “transferred” personal incometax, as determined in the Budget Act (37.9 bil-lion HUF in 1999, and as much as 108 billionHUF in 2008). Changes in the tax capacitycaused a constant increase in the number oflocal authorities concerned by the decrease,and in the amount of the state aid withdrawn.(2.3 billion HUF was withdrawn from 55 localauthorities in 2000 and as much as 8.7 billionHUF from 83 local authorities in 2001.)

It is important to emphasise that dependingon the tax policy of local authorities, the localbusiness tax collected may differ from theactual tax capacity due to decisions aboutintroductions, tax rates, exemptions, andallowances. To calculate the amount of revenuewithdrawal and supplements, the tax capacitycalculated in the manner determined in theBudget Act is to be applied.

Since its introduction, the rules of calculating

tax capacity have changed. Instead of data from

the Hungarian Tax and Financial Control

Administration (APEH), it is based on local

business tax returns. The difficulties in the

planning process are illustrated by the fact that

due to bad estimates, 6.9 billion HUF was with-

drawn from 1288 municipalities in the course of

the year-end financial settlements in 2007. In

2008, 94 per cent of settlements are receiving

supplements, while 3 per cent are concerned by

withdrawals due to their tax capacity taken into

account, which is to alter the differences in per-

sonal income tax and local tax revenues per

inhabitant among the counties. In 2008, an

amount of 108.6 billion HUF from the person-

al income tax is used to soothe the differences

in revenues. As a result, tax capacity and per

capita personal income tax in the capital city

decrease from 90,198.6 HUF to 76,545.4 HUF,

while in the villages, they increase from 15,332

HUF to 37,945 HUF. The amounts of person-

al income tax and state contributions that local

authorities are entitled to are published in the

form of a breakdown by municipalities and

titles in a joint decree by the Ministry of

Finance and the Ministry of Local Government,

drawn up based on the annual Budget Act.

Figure 6 demonstrates the distribution oflocal authorities according to local business taxfigures in tax returns.

Among local authorities levying local busi-ness tax in 2000, 11.5 per cent had local busi-ness tax revenues of under 100 thousand HUF.By comparison, 10 per cent had local businesstax revenues of over 50 million HUF.

According to the 2007 local business taxreturns processed, the countrywide average taxrate was 1.88 per cent (as opposed to 1.47 percent in 2000), which represents a 94 per centtax rate exploitation (as opposed to 86.5 percent in 2000) in view of the statutorily provid-ed 2 per cent (1.7 per cent in 2000).

Regarding communal tax payable by enter-prises, the average tax rate compared to thestatutorily provided maximum was 90 per centin 2006 (as opposed to 87.6 per cent in 2000).By contrast, regarding communal tax burden-ing inhabitants, tax rate exploitation was of 51per cent (as opposed to 15 per cent in 1996 and30 per cent in 2000).

Increasing local tax revenues regardless ofeconomic performance has primarily been dueto local authorities' budgetary revenue “con-straints”. As a result, huge differences have


670

developed among the local tax burdens of dif-ferent settlements (areas). Local authoritieswith considerable other resources of their own(primarily sale of assets revenues) had createdmore favourable investment and entrepreneur-ial environments, relying on the tools of taxpolicy (rates, exemptions, allowances), whichpractice was later “restricted” by Hungary's EUaccession.10

SUMMARY AND LESSONS TO BE LEARNT

Since 1990, local public finance has been char-acterised by an ever increasing (public) taskdecentralisation (further extended by specific,sector-related Acts in certain cases), decreasingrepresentatives' freedom of decision regardingbudgetary issues. The audits conducted by theState Audit Office have shown that the sumleft to finance voluntarily undertaken tasksamounts to an average of 2–3 per cent of theannual expenditures in the case of county levellocal authorities, an average of 3–6 per cent inthe case of the village municipalities, and anaverage of 10 per cent in the case of town andcity municipalities.

Local authorities provide public services, andquality public services, primarily depending on

financial (budgetary) constrains. Apart fromthe general tasks deemed compulsory by theAct on Local Authorities, (such as primary andsecondary education, provision of standardhealth care and social services, provision ofhealthy drinking water, maintenance of localpublic roads, operation of public cemeteries,etc.), specific, sector-related acts may alsocharge them with compulsory tasks relating topublic services and official authority. State sup-ports and contributions for the so-called com-pulsory (public) task performance are providedby the central budget based on task indices, andthrough 200 different titles and normative con-tributions. The term itself renders it obviousthat the total funds requirement of compulso-ry (public) task performance is not fully pro-vided by the central budget. (Nor is it expect-ed to be in the next few years.) Consequently,regarding local public finance, the role andweight of local taxes and local authorities' ownrevenues are further increasing.

Support value revenues received from thecentral budget and other sub-systems of publicfinance (mainly from social security and theLabour Market Fund) still have a part, albeit toa decreasing extent, in the budget of the overthree thousand local authorities and their annu-al financial management. As part of a contrary

Figure 6

DISTRIBUTION OF LOCAL AUTHORITIES ACCORDING TO LOCAL BUSINESS TAX FIGURES IN 2007

50 million HUF; 13%

10–15 million HUF; 22%


0 HUF; 15%

1–100 thousand HUF; 2%

100–500 thousand HUF;7%

500–1000 thousand HUF;7%



671

process, the proportion of local authorities'own revenues, and within these the weight oflocal taxes, have been growing steadily. Theproportion of local authorities' own revenuesin the financing of their compulsory and vol-untary (public) task performance has also beengrowing continuously. Since the establishment ofthe system of local governance, the proportion oflocal authorities' own revenues has grown from21 per cent in the first years to 27.5 per cent.Steady growth is especially important as it is aprerequisite of the existence of local authori-ties' own funds necessary for the differentinvestment and development projects to beimplemented within the approved “EconomicProgrammes”, which is the “entry ticket” nec-essary to be able to avail of any EU develop-ment money.

The Hungarian tax system is characterised bythe predominance of central taxes. Local taxes-except for local business tax – play an insignif-icant part. Among local taxes, it is necessary tohighlight property-type taxes. In their presentform, tax on buildings and land parcel tax donot represent actual taxation of property at all.The necessity of equitable contribution to pub-lic revenues based on property, and thus theincrease of local authorities' own revenues are arecurring theme of fiscal policy. In the next fewyears, it will be impossible for the economic poli-cy to avoid introducing property tax; however,careful preparation and inserting it into a sys-tem are both necessary.

Unfortunately, it must be mentioned herethat so far no appropriation account closing bal-ance has included a full and ad valorem invento-ry of the financial situation of the state and localauthorities regarding properties (whereas thesame is a financial-legal requirement towardsnatural persons as taxpayers), even though thatshould be a prerequisite of equitable contribu-tion to public revenues based on property.

The international practice of taxing realproperties, which is traditionally most typical

of Anglo-Saxon countries, where imposing atax on real properties is value-based, and is thusequitable, may offer Hungary several lessonsregarding social issues and tax law. Having noexperience in this field, we have been averse toimposing a value-based tax on real propertiesso far, partly because it requires changes in taxmanagement.

Regulating, managing and operating thewhole tax system, and (for example, due to theoverestimation of expected tax revenues fromluxury tax) revising some of its structural ele-ments is a financial, legal requirement, in thecourse of which it is necessary to determine whatsort of system of tax, contribution, charge, andduty regulations we wish to maintain in thefuture. It is widely known that both the impactof the EU budgetary and economic determina-tions11 and our Constitution in effect requirethat our tax system be reassessed. Regardingthe scope of basic rights and obligations, theConstitution stipulates that “in the HungarianRepublic all Hungarian citizens have the obli-gation to contribute to public revenues on thebasis of their income and wealth”. For variousreasons, the requirement of equitable contribu-tion to public revenues is not fulfilled as it shouldbe expected to be, and there exists no flat prop-erty tax. Equitable contribution to public rev-enues, securing public expenditures, durability,traceability, and especially the provision ofallowances for “those in the tattered socialsafety net”, i.e. those in need mostly existed atthe level of goal setting.

A predictable tax system may only be con-structed together with a reform of public finance,provided that their timing and contents are inharmony. These two will naturally affect therole and weight of local taxes, and thus theoperation of local public finance and the finan-cial management of local authorities. TheHungarian State Audit Office attempts to pro-mote changes pointing in this directionthrough their audits, reports and suggestions.


672

1 Act XV./1997 on the Proclamation of theConvention entitled “European Charter of LocalSelf-Government”, done at Strasbourg on October15, 1985

2 In Budapest, both the Municipal Assembly and therepresentative bodies of the individual districts areentitled to introduce local taxes; however, the dis-tricts are not entitled to impose a local tax typealready introduced by the Municipal Assembly ontheir taxpayers.

3 To read the reports see www.asz.hu.

4 The four subsystems are the central budget, localauthorities, social security, and separate state funds(such as the Labour Market Fund, the CentralNuclear Fund, the Wesselényi Miklós Flood andInland Waters Protection Fund, etc.).

5 Without loan revenues and revenues deriving fromthe sale of securities, and filtering out accumulationswithin public finance.

6 In 2007, there were 52 different titles in effect relat-ing to our obligations to contribute to public rev-enues. (See Appendix 1.)

7 The tax base of the local business tax is calculatedbased on the net turnover of the products (services)sold. (Factors that decrease the tax base to take intoaccount are: the value of stocks purchased solely forresale, subcontractor's performance (for mediatedservices), and material costs).

8 Tax capacity of the local authority: 1.4 per cent of thetax base determining the advance payment of localbusiness tax in the budgetary year.

9 ÖNHIKI: acronym for municipalities disadvantageddue to circumstances beyond their control, for theaid of which municipalities the central budget hasannually separated funds.

10 As far as the provision of different central and localaids and supports is concerned, subsequent toHungary's EU accession, the country was providedwith a grace period until the end of 2007.

11 The convergence criteria relate to inflation, theinterest rate, the budgetary deficit, the proportionof the government debt to the GDP, and the stabil-ity of the exchange rate. All these set limits to theresources received by local public finance from thecentral budget.

CSECSERITS, I. (MRS.), NÉMETH, G. – LÓRÁNT, Z.(2006) On the financial management of local publicfinance, SALDO Local Governance Booklets,Budapest

KOVÁCS, Á. – LÓRÁNT, Z. (2003): The functioningof public finance and state assets and their audits,ELTE Institute of Postgraduate Legal Studies,Budapest

Local authorities and their finances, Consulting Rt.,Budapest, 1998

Preliminary study for the audit of the tax collectingactivities of local authorities, State Audit Office ofHungary, Budapest, 2008

Reports on the audit of the tax collecting activities ofmunicipalities, State Audit Office of Hungary, 1996, 2001

LITERATURE

NOTES


673

1. personal income tax

2. value added tax

3. corporate income tax

4. solidarity tax

5. financial institutions' contribution

6. simplified entrepreneurial tax

7. simplified public charges contribution

8. spirits tax

9. tax on buildings

10. land parcel tax

11. communal tax payable by private individuals

12. communal tax payable by entrepreneurs

13. tourism tax

14. local business tax

15. luxury tax

16. motor vehicle tax

17. vehicle registration tax

18. energy tax

19. duties

20. excise duty

21. environmental protection product charge

22. emission charge (emission charge for air pollution,

emission charge for water pollution, emission

charge for soil pollution)

23. innovation contribution

24. training levy

25. rehabilitation contribution

26. employers' contribution

27. employees' contribution

28. entrepreneurs' contribution

29. health care contribution

30. employers' pension insurance contribution

31. employers' health insurance contribution

32. employees' pension contribution

33. employees' health insurance contribution

34. health care service contribution

35. gambling tax

36. cultural contribution

37. mining royalty

38. breeding contribution

39. water resource contribution

40. forest maintenance contribution

41. game preserving contribution

42. land protection contribution

43. land protection levy

44. television operation fee

45. fishing development contribution

46. medicine distributors' payments

47. medicine dealers' payments

48. pharmacy solidarity charge

49. medicine presentation payment

50. medical appliances and equipment presentation

payment

51. risk of medicine support surplus

52. customs duties

APPENDIX 1

TAX AND PUBLIC REVENUE TYPES IN EFFECT IN 2007


674

CHANGES IN THE REAL VALUE OF THE REVENUES OF LOCAL AUTHORITIES, 1991–2007

Year GFS system revenues of local Value index Consumer Volume (Realauthorities (HUF bn) (%) Price Index (%) value) index (%)

1991 386 – – –1992 502 130.1 123.0 105.71993 581 115.7 122.5 94.51994 730 125.6 118.8 105.81995 813 111.4 128.2 86.91996 936 115.1 123.6 93.11997 1 168 124.8 118.3 105.51998 1 304 111.6 114.3 97.71999 1 499 115.0 110.0 104.52000 1 656 110.5 109.8 100.62001 1 904 115.0 109.2 105.32002 2 181 114.5 105.3 108.82003 2 501 114.7 104.7 109.52004 2 673 106.9 106.8 100.12005 2 891 108.2 103.6 104.42006 3 053 105.6 103.9 101.62007 3 081 100.9 108.0 93.42007/1991 798.6 692.4 115.3

CHANGES IN THE REAL VALUE OF THE EXPENDITURES OF LOCAL AUTHORITIES, 1991–2007

Year GFS system revenues of local Value index Consumer Volume (Realauthorities (HUF bn) (%) Price Index (%) value) index (%)

1991 374 – – –1992 498 133.3 123.0 108.41993 599 120.4 122.5 98.31994 750 125.2 118.8 105.41995 800 106.7 128.2 83.21996 913 114.1 123.6 92.31997 1 135 124.3 118.3 105.11998 1 348 118.8 114.3 103.91999 1 476 109.5 110.0 99.52000 1 651 111.9 109.8 101.92001 1 902 115.2 109.2 105.52002 2 286 120.2 105.3 114.22003 2 533 110.8 104.7 105.82004 2 690 106.6 106.8 99.82005 2 972 110.5 103.6 106.72006 3 210 108.0 103.9 103.92007 3 135 97.7 108.0 90.52007/1991 844.1 692.4 121.9

Forrás: Pénzügyminisztérium, Központi Statisztikai Hivatal

APPENDIX 2


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T

József Papp

Freeing the hamstrung economy

The biggest problem of the Hungarian economy isthat the heavily taxed white economy and the greyeconomy, which optimises tax payment by reduc-ing it to the minimum, hamstring each other:“due to the funding needs of public expendituresthat are excessive compared to the performance ofthe economy, high personal income tax and con-tributions should be paid. However, the SME sec-tor is uncompetitive with prices that include alltaxes and public dues payable on the wages ofemployees as required by law. Overtaxed house-holds are also unable to pay for goods and servic-es produced in the grey economy the price thatincludes all taxes and contributions! On top ofthat, those layers of the society that are unable toavoid tax payment must be heavily taxed becauseof the excessive size of the grey economy, the play-ers of which hardly pay any taxes. And the greyeconomy is so swollen because of the unbearablyhigh tax and contribution burdens!” (József Papp,2006) Being so hamstrung makes the Hungarianeconomy uncompetitive and unable to grow.

In this study I am going to prove that even ifit wanted to, an average small Hungarian enter-prise could not pay all the taxes and contribu-tions, since it cannot produce as much addedvalue as would be necessary to cover theemployees' income, the expected profit of theentrepreneur, as well as all the deductionsrequired by the state. Tax evasion is an objec-

tive necessity! In today's Hungary mostemployees of small and medium-sized compa-nies – several hundreds of thousands of people– work in a two-channel wage system: they paytaxes on declared wages that are close to theminimum wage, and receive the other part oftheir earnings illegally, in cash. Enterprises canremain competitive only by maintaining thisstructure, which is beneficial for nobody.

At the same time, those players of the econ-omy that could pay the high tax rates pay lessthan they should, or pay no tax at all. The high-ly productive multinational companies receiveso much central support and tax benefits thattheir actual tax burden is significantly lowerthan the amount of taxes and contributionspayable on the basis of the actual tax rates.What is more, the hidden economy has a muchtoo big segment – first of all in the cateringindustry, trade, services to the population, agri-culture and the construction industry – theplayers of which pay no taxes at all, althoughthey would be able to do so.

With the help of a model I am going to provethat a radically transformed tax system that isbased on the realities is able to free the ham-strung Hungarian economy, create a climatethat can release the entrepreneurial energiessuppressed by the current tax system, createthe conditions for fast economic growth, and is


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able to ensure the revenue sources of a reason-ably reformed budget. In the new tax systemthe taxes and contributions payable on wagesand enterprises would significantly decrease onone side. On the other side, though, the formerVAT rate of 25 per cent would be reinstated,and a temporary wealth tax (not just propertytax) would be introduced. Concurrently witheasing the tax burdens of the enterprises, thesanctions on tax evasion must be drasticallytightened: the general public should considertax evasion a capital crime.

Today a growing number of people believethat it is inevitably necessary to reduce wagedeductions and to radically transform the taxsystem. I am glad to see that this topic, whichfundamentally influences our life and future,has become common talk. I hope that based onits novel approach, this study will be able toshed a new light on the basic issues to be solvedand will help us find the right answers.

Only the thorough and deep analysis of thetwo-channel wage system can lead us to thespecification of the optimum tax rates.Unfortunately, researchers have not yetanalysed the phenomenon of illegal cash pay-ments. This study is making the first steps onthis way. I have been thinking for a long timeabout the responses of Hungarian enterprisesto the challenges inherent in the high tax bur-den. I have interviewed a lot of entrepreneursduring the past years, I have studied and sys-temised pieces of news on illegal cash pay-ments. This study combines these broad empir-ical experiences with the results of the corpo-rate model presenting the changes of the taxsystem. The novelty of the study lies in the factthat it presents and justifies the macro-levelconsequences of the changes in the tax burdenby modelling the volume and distribution ofthe GDP produced at micro-level, by the givencompany.

The new tax system proposed in this study isof course only one possibility to enable the

Hungarian economy to break out of its cur-rent, disgraced situation. Not necessarily theproposed measures, but some similar onesmust be taken, there is no other way out. Thesooner we set to it, the more successfully wewill get through. If we are waiting until suffi-cient cover is accumulated in the budget for taxreduction, this type of tax reform will never beimplemented!

UNBEARABLY HIGH TAX WEDGE

In the so called two-channel wage system,which has emerged in the SME sector out ofnecessity, employees are compensated for theirwork in the form of taxed (declared) wage andillegal cash payments. This is a reality that eventhe tax authority is perfectly aware of.Although the tax authority is using increasing-ly efficient methods in its fight, it cannot elim-inate the phenomenon of illegal cash payments.The reason behind this is that for a majority ofenterprises engaged in this practice, the unlaw-fulness manifesting in tax evasion is an objec-tive necessity: due to their insufficient incomegenerating ability they must give part of thewages untaxed, otherwise they would go bank-rupt. And if they went bankrupt, their employ-ees that have little value on the labour marketwould end up on the street. The state knows itwell, too, this is why the legal sanctions thatcan be imposed on fictitious invoicing (whichmakes cash payments possible), and on theunderlying bogus company schemes are rather“entrepreneur-friendly”, and have no deterringeffect. In Hungary there are thousands oftransactions every day in which the entrepre-neurs in need purchase fictitious invoices inorder to withdraw money from the company tocover in part or in full the employees' wages(and/or their own profits, or the bribe moneyinevitable for getting by).

But what does fictitious invoicing actually


677

mean? To understand it, let us first see how thechannels of legal withdrawals work. One canlegally withdraw money from a company onlyin two ways: as wage income or in the form ofowner's profit (dividend). The tax burden onwage withdrawal is unbearable for many enter-prises, and this is the biggest problem of theHungarian economy. Table 1 provides anoverview of the current rates of taxes and con-tributions payable on wages.

The employer pays a contribution of 33.5 percent on the gross wage. In addition, the per-sonal income tax of 18 to 36 per cent, as well asthe employee contribution of 17 per cent arededucted from the gross wage. Low grosswages make the earners eligible for tax credit,equalling HUF 11,340 per month if the annualincome is below HUF 1,250,000. From theincome falling between this amount and HUF2,762,000 nine per cent can be accounted as taxcredit each year. High-income private individu-als must pay a four per cent solidarity tax ontheir income portion above the HUF 7,137,000limit.

Today it is almost commonplace that“…from among the OECD member statesonly Belgium imposed higher taxes on wageincomes than Hungary. The Hungarian figure

is especially noteworthy in the light that thededuction rate is outstandingly high comparedto the competitors of the region – and usuallythe lower income OECD member states.Therefore, from among the Visegrád countriesHungary can boast with the smallest net wages.(See Chart 1)

The tax and contribution burden (the socalled tax wedge) accounted for 54.4 per centof all labour costs in Hungary. The figures ofthe comprehensive OECD study show: the taxburden is 10 to 15 per cent higher than in theother countries of the region.” (Portfolio.hu,2008)

According to Lajos Bokros, the unbearablesize of the tax wedge is the biggest obstacle toeconomic growth.

“The literature on taxation calls the ratio ofall public dues payable on the net wage and theentire wage costs tax wedge. This indicator issignificant since it influences market behav-iour; it fundamentally influences the behaviourof both the employer and the employee. Theemployee is first of all interested in the netwage, i.e. the income in hand, while theemployer is interested in the gross wage.

The tax wedge is extremely high in Hungary.Considering an average PIT of 24 per cent, and

Table 1

WAGE DEDUCTIONS(per cent)

PIT tax rate, if the annual gross wage is less than HUF 1,700,000 18.0PIT tax rate, if the annual gross wage is more than HUF 1,700,000 36.0Employee contributions 17.0

Pension contribution 9.5Healthcare contribution 6.0Employee contribution 1.5

Tax credit/month (HUF) 11,340Contributions payable by the employer 33.5

Pension contribution 24.0Healthcare contribution 5.0Employers taxes 3.0Vocational training contribution 1.5Flat-rate healthcare contribution (HUF) 1,950


678

calculating with the employer contribution of 32per cent and the employee contribution of 17per cent, as well as with a certain average of theflat-rate healthcare contribution, the tax wedgeequals 56 per cent. In the case of citizens whoalso pay solidarity tax, this value grows to 66 percent, which means that the tax system deductstwo thirds of the income equalling the grosswage costs. Their employment costs three timesmore for the employer than the income theyfinally receive. This high tax wedge – whichalready affects the majority of middle-classincomes – can in no way encourage employeesto work more, or to encourage employers tocreate more jobs.” (Lajos Bokros, 2008)

For an average Hungarian small enterprisethe excessive tax wedge makes the withdrawalof wages unbearably expensive. The paymentof a net wage of one Forint would require theproduction of an added value 1.5–2 times that

size in order to pay the wages and the relatedcontributions.

Dividends are a cheaper way of withdrawal:dividend can be paid by paying the 25 per centdividend tax on the after-tax profit (16 per centcorporate income tax and 4 per cent solidaritytax). The tax wedge of capital income is only 40per cent, i.e. relatively low compared to wageincome, yet this option is seldom used insteadof the withdrawal of wage income. Earlier itwas set aside because the dividend had to beprojected on the equity of the enterprise, and ifthat ratio was higher than twice the centralbank's basic interest rate, the dividend abovethat value was taxed practically to the sameextent as wages. This provision was revoked,however due to the tightening of anti-moneylaundering regulations and the threat of wealthgain investigations few entrepreneurs under-take to pay cash to their employees from divi-

Chart 1

TAX WEDGE IN THE OECD COUNTRIES(per cent)

Source: OCECD, Portfolio.hu

Belg

ium

Hung

ary

Germ

any

Aust

ria Italy

Swed

en

The

Neth

erla

nds

Finl

and

Czec

h Re

publ

ic

Pola

nd

Turk

ey

Gree

ce

Denm

ark

Spai

n

Slov

akia

Norw

ay

Luxe

mbu

rg

Portu

gal

Grea

t Brit

ain

Cana

da

USA

Switz

erla

nd

Japa

n

Icel

and

Aust

ralia

Irela

nd

Kore

a

Mex

ico


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dends due to the risk inherent in the regularwithdrawal of large amounts of cash. Once therisk exists, they prefer the illegal channel ofcash withdrawal, i.e. fictitious invoicing, whichimplies temptingly low tax burdens.

TWO-CHANNEL WAGE PAYMENT

The owner or the managing director thus with-draws the cover of wages paid in cash as thecountervalue of the fictitious invoices, by wayof fraud. The issuer of the fictitious invoicethat is usually paid by bank transfer and not incash returns the greater part of the money(gross invoice value minus VAT) to the ownerof the enterprise in cash, who can use thismoney to pay part of the employees' wages incash. Naturally, the VAT computed on the fic-titious invoice is deducted from the VAT to bepaid to the budget. In reality, the issuer of thefictitious invoice (which can be an overinvoicedpart of a real invoice, but then the issuer of theinvoice must buy a fictitious invoice to coverthe overinvoiced part) does not provide anyreal service to the recipient of the invoice,other than making cheap and illegal cash with-drawal possible. The price for this “service” isusually 10 per cent of the net invoice value. Ifthe entrepreneur does not pay the VAT either,the profit of the issuer of the fictitious invoicefrom the transaction equals 30 per cent of thenet invoice value. This is a temptingly easy wayof making money, thousands of people get richon it despite the fact that conducting this busi-ness implies serious risks due to being illegal.

Nonetheless, fictitious invoicing does notprimarily constitute VAT and corporateincome tax frauds (naturally, those crimes arealso involved), as it is suggested by the mediaand treated by the authorities.

[The National Bureau of Investigation startedinvestigating the company headed by István Sz.after a bank reported a suspected money-laun-

dering case. Later it turned out that Sz. and hisaccomplices had established several companiesin the names of homeless people, foreigners andjobless people who once saw better days withthe help of lawyers (and an apprentice lawyer).These construction, machinery part trading andcleaning companies that existed merely on paperissued fictitious invoices for anybody for VATreclaims or the reduction of the corporateincome tax base.] (Attila Fekete Gy., 2007)

“Entrepreneurs buy such “services” not tohide their profits but to withdraw the moneythey give their employees in cash with thesmallest possible burden”. (József Papp, 2007)The “tax wedge” of fictitious invoicing isunbeatably low compared to the unbearablyhigh dues payable on wages or even dividends.

Table 2 presents the operation of the two-channel wage system and the savings that canbe achieved by its use. The declared monthlygross wage of the employee is HUF 140,000,plus he receives a net cash payment of HUF50,000 from the owner of the enterprise. Thefirst column of the table calculates the dues ofthe two-channel system and the actual netearnings, while the second column shows thegross wage and the public dues for the same netwage if all taxes and contributions were paid.

The savings are shocking: assuming averagewages, the company can save HUF 108,663 amonth per employee using the above-men-tioned two-channel scheme. (In 2007, the aver-age monthly gross wage in the competitive sec-tor was HUF 177,376, excluding, naturally, thecash payments.) By evading the enormous taxwedge implied in legal wage payment, theentrepreneur, i.e. the employer of the employ-ee maintains a wage system that is illegal, how-ever the implied tax wedge is only 39 per cent,which practically corresponds to the duespayable on dividends. This means that the taxand contribution savings so achieved equalalmost twice the net invoice value of the ficti-tious invoice accounted in the books.


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But who benefits from these savings? Is itthe tax evading entrepreneur, or nobody,since these savings are only virtual savingsgiven the fact that due to the low level ofproductivity the enterprise is unable to pro-duce the added value that would serve as acover for these savings, and this is whatforces the owner to be engaged in fictitiousinvoicing. Unfortunately, in the overwhelm-ing majority of the companies this the case:the average Hungarian entrepreneur cannotcompete at a price that would cover all costs,including all wage related costs and contribu-tions. As the well-known IT entrepreneurPál Vadász complained in a lecture: “the mar-ket is not willing to pay these prices”. (PálVadász, 2006)

With Tables 3 and 4 Pál Vadász proves thateven the IT sector, which produces high addedvalue, is unable to set prices that are sufficientto pay all wage related costs.

If the entrepreneur paid all dues, he wouldhardly have any margin for other costs, not tomention his profits. Naturally, Vadász is notsaying that fictitious invoices must bebought, but rather that dues should bereduced. However, the memorable scandals ofthe IT sector testify about the fact that evenlisted IT companies, such as Synergon Rt,apply the practice of fictitious invoicingextensively.

“In its appealable ruling announced onTuesday the Court of the City of Pécs foundTibor Vagyon, the figurehead of the infamous

Table 2

SAVINGS ON WAGES PAID IN CASH

Two-channel Wages with all wage system taxes paid at the

current rates

Costs of purchasing fictitious invoices as a percentage

of the net invoice value, % 10.0 0.0Average monthly gross wage per person (HUF) 140,000 263,011

Employee's dues 23,800 44,712

Tax credit 8,115 0

Actual PIT 17,085 69,184

Actual PIT rate, % 12.2 26.3

Net wage 99,115 149,115

Wage supplement in cash 50,000 0Total actual net wage income 149,115 149,115

Employer's contribution burdens 48,850 90,059

Net value of the fictitious invoice needed for the withdrawal

of the wage supplement 55,556 0

Costs of purchasing fictitious invoices 5,556 0

Actual burdens of the employer 104,406 90,059Total costs of employment 244,406 353,069

Structure of the costs of employment, % 100.0 100.0

Total net wage income, % 61.0 42.2

Total dues payable, % 39.0 57.8

Contributions and taxes, % 36.7 57.8

Costs of cash withdrawal, % 2.3 0.0


681

company group known as the Pécs invoicefactory guilty in committing businesslike,cumulative fraud causing especially greatdamage, and sentenced him to seven years inprison. His accomplice, who was the defen-dant in the second degree out of the 27 defen-dants in the criminal proceeding was sen-tenced to three years in prison. According tothe Court, the prosecution proved that thestate had suffered a loss of nearly HUF 1 bil-lion due to the use of fictitious invoicesissued on various activities and in variousamounts by companies belonging to TiborVagyon's invoice factory between 1997 and2000. According to the court, nearly two-thirds of the fictitious invoices were acceptedby Synergon Rt. The prosecution broughtcharges against several managers of the com-

pany, however the court acquitted all of thembut former CEO Zsolt Szalóczy from thecharges. Szalóczy was sentenced to five yearsof imprisonment and a fine of HUF 2 million.Furthermore, he was deprived of his basicrights for several years, as well as of the rightto hold leading positions in any businessorganisation. Then, without the motion ofthe prosecution, the court ordered his pre-trial detention due to the gravity of the sen-tence.” (Attila Fekete Gy., 2003)

At the time of the case Synergon Rt.employed over 300 employees. And althoughthe company flourished, and kept receivingjuicy assignments, paying the wages of so manyhighly qualified IT specialists while paying alltaxes legally caused a problem even for the starcompany.

Table 3

CAN WAGE COSTS BE OFFSET BY PRODUCTION

Average invoiced hourly fee of IT professionals on the market HUF 9,000/hour

Expected net hourly fee of IT professionals HUF 3,000/hour

No. of working hours/month 160 hour

Net amount payable HUF 480,000

Related gross wage HUF 910,000

Employer’s per capita total costs* HUF 1,216,800

Sales revenues produced by the employee* HUF 1,440,000

GROSS MARGIN 15,5%

* 84,5% of the prodeced sales revenue (margin) represents wage costs!

Table 4

WHEN WOULD THESE PUBLIC DUES BE BEARABLE?

Average invoiced hourly fee of IT professionals on the market HUF 13 500/hour*

Expected net hourly fee of IT professionals HUF 3 000/hour

No. of working hours/month 160 hour

Net amount payable HUF 480 000

Related gross wage HUF 910 000

Employer’s per capita total costs HUF 1 216 800

Sales revenues produced by the employee HUF* 2 160 000*

GROSS MARGIN 56,3%

* With the currnt public dues an average invoiced hourly fee of HUF 13,500 would be needed instead of the hourly fee of HUF 9,000!

Source: Pál Vadász: The emperor is naked or can wage costs be offset by production? Roving conference of economists, Nyíregyháza, 2006


682

THE GDP IS NOT SUFFICIENT FOR THE PAYMENT OF ALL TAXES AND CONTRIBUTIONS

The application of the two-channel wage sys-tem in the small and medium-sized sector hav-ing a low productivity is the precondition forsurvival. In these companies the GDP peremployee is painfully low, it is less than half ofthe average value of HUF 8.515.000/employ-ee/year measured in 2006. (See Chart 2)

The research conducted by Zoltán Pittiextensively supports the assumption accord-ing to which the Hungarian economy is divid-ed to the extreme, and shows a dual structure.The income generating ability of Hungarianowned companies – practically the SME sector– is only a fraction of the income generating

ability of foreign owned companies.According to Pitti, the situation is simply cat-astrophic compared to the EU average:“...there are 1,250,000 businesses for the 5million active Hungarian citizens, but onethird of these businesses do not operate. The600 limited partnerships and private entrepre-neurs produce only 4.5 per cent of the GDP.[...] In Hungary, performance per employeeequals only one third of the EU average, butin the case of partnerships owned exclusivelyby Hungarians, this ratio is only 15 per cent.At the same time, these companies employ 76per cent of Hungarian employees. As much as57 per cent of new entrants to the labour mar-ket have qualifications, the remaining 43 percent are trying to get by withoutthem.”(Origo.hu, 2008)

Chart 2

ADDED VALUE PER EMPLOYEE AT HUNGARIAN COMPANIES (1998–2006)

Source: Zoltán Pitti: The role of innovative enterprises in the implementation of the economic policy objectives, Interim report on research carriedout in 2007 and 2008 by the Prime Minister's Office and the Hungarian Academy of Sciences, Hungarian Academy of Sciences, 2008

100% Hungarian owned100% foreign owned

joint venture (Hungarian majority)joint venture (foreign majority)

76.2% of the employees in the competitive sector workfor exclusively Hungarian owned, but not highly pro-

ductive companies

HUF million/person


683

Due to the low productivity of Hungarianowned enterprises this sector is simply unableto generate as much GDP as it would be neces-sary for paying all expected taxes and contribu-tions. In the following we model that an aver-age small enterprise employing twenty persons(Company A) is unable to pay all dues even ifits productivity exceeds the sector specificaverage productivity rate. Let us assume thatthe two-channel wages presented in Table 2present the average earning relations of theenterprise. This company pays each employeean average monthly gross wage of HUF140,000 plus HUF 50,000 in cash on average.(Of course, there can be employees on whosewages all dues are paid, and there can be otherswho get all of their wages in cash. Pitti's wordsalso explain why employees receiving part orthe entirety of their income in cash do notobject to the fact that little or no contributionis paid for them, which jeopardises their futurepension benefits. They do not protest becausedue their low level of qualification their labourmarket position is so weak that they areemployed only if they accept the conditions ofthe unfavourable two-channel wage system.)

The model presented in Table 5 counts withthe fact that the GDP produced by an employ-ee of Company A equals 60 per cent of thenational average, which is significantly higherthan the average production of Hungarianowned enterprises. The entrepreneur shoulduse the GDP of HUF 102 million to pay thewages, the accompanying contributions andother taxes (VAT, corporate income tax, soli-darity tax, dividend tax, local business tax), theowner's withdrawals (dividends) – as well asbanking costs – and for accumulation, invest-ments and development. Putting it simple, theGDP produced by the company is the differ-ence between the gross revenues and the grossvalue of purchased goods and services. Themodel calculates the corporate income tax andthe dividend tax on the basis of the current tax

rates, provided that the owner of the companywithdraws all after-tax earnings as dividend,and reinvests nothing. In the first column themodel shows the GDP produced by the com-pany according to wages paid in the two-chan-nel wage system. The second column shows thesituation that would occur if all dues were alsopaid on the net cash payments. The bottompart of the table shows the distribution of theGDP among net wages, all dues paid andowner's withdrawals. (In the model the deduc-tions include the dues on wages, the VAT, thecorporate income tax, the solidarity tax and thedividend tax.)

By studying the results of the model we maydraw several conclusions. By purchasing ficti-tious invoices in the amount of HUF 13.3 mil-lion, Company A can save twice as much on thecosts of employment, since it pays less wagerelated taxes and contributions. Should it actotherwise, it would practically have no profitsat all. With the given income generating abilitythe owner of the company can realise profitsonly by evading taxes and forcing his employ-ees to do so, too. It is terrifying even to thinkthat if Company A paid all taxes, the statewould deduct 65 per cent of the GDP it gener-ated! This is mere nonsense!

Profit maximisation – the goal of entrepre-neurial activities – can only be achieved by theintroduction of the two-channel wage system.However, the remaining income is still insuffi-cient for development, investments or for thecreation of the conditions for growth. There isno doubt that the unbearable size of wage relat-ed taxes and contributions is the largest obsta-cle to the growth of the Hungarian economy!

(It is worth noting that the official value ofthe GDP per employee indicated in the modelis much lower in reality if private entrepre-neurs and self-employed micro-enterprises arealso listed among employees. In their note-worthy study titled “How did we get here:Hungarian budget 2000–2006” László


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Ohnsorge–Szabó László and Balázs Romhányiestimate this value to be HUF 4,966 million.If this is true, the statement according towhich the average Hungarian small enterprisecannot produce as much GDP as would benecessary to pay all dues on wage income iseven more relevant!)

With the help of the model it is worth scru-tinizing the problem of the IT sector – whichproduces high added value – described by PálVadász. Table 6 presents the GDP produced byCompany B. Company B employs 50 employ-ees and pays an average gross wage of HUF350,000 and HUF 250,000 in cash to each

Table 5

DISTRIBUTION OF THE GDP PRODUCED BY COMPANY A

Two-channel Fully taxed wage system wages at the

current rates

Costs of purchasing fictitious invoices as a percentage

of the net invoice value, % 10.0 0.0

Corporate income tax and solidarity tax, % 20.0 20.0

Dividend tax , % 25.0 25.0

VAT, % 20.0 20.0Average monthly gross wage per person (HUF) 140,000 263,011

Wage supplement in cash 50,000 0 Total actual net wage income 149,115 149,115

Total costs of employment 244,406 353,069

GDP per employee in Hungary in 2006 (HUF thousand) 8,515 8,515

Number of employees 20 20

GDP per employee at the company relative to the national average

in Hungary in 2006, % 60.0 60.0Gross added value (GDP) 102,180,000 102,180,000

Total costs of employment/year 58,657,333 84,736,609

Net after-tax wage 23,787,600 35,787,600

Total contributions and taxes 21,536,400 48,949,009

Net value of the purchased fictitious invoices 13,333,333 0

Part of the revenue that remains after the deduction of costs other

than employment costs (net added value) 85,150,000 85,150,000

Payable VAT=VAT of the added value 17,030,000 17,030,000

Pre-tax profit 26,492,667 413,391

Corporate income tax and solidarity tax 5,298,533 82,678

Profit and loss according to the balance sheet 21,194,133 330,713

Dividend tax 5,298,533 82,678

Owner's withdrawal (taxed dividend) 15,895,600 248,035 Total taxes and contributions 49,163,467 66,144,365

Distribution of the gross added value, % 100.0 100.0

Taxes and contributions, % 48.1 64.7


Owner's withdrawal, % 15.6 0.2

Commissions paid to fictitious invoice issuers, % 1.3 0.0


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employee. This more or less equals the expect-ed net income of HUF 480,000 stated inVadász's presentation. The per capita GDP(180 per cent of the national average) is alsoclose to the HUF 15 million shown in the pres-entation.

The table shows that if Company B paidthe gross wage of the expected net income

and all the related contributions, it wouldincur a loss or nearly HUF 70 million.Therefore, the model had to be expandedwith the “loan from the owners” variable usedfor compensating the incurred loss. Thismeans that in order to enable Company B tomeet all of its tax and contribution paymentobligations, the owner would be required to

Table 6

DISTRIBUTION OF THE GDP PRODUCED BY COMPANY B

Two-channel Fully taxed wage system wages at the

current ratesCosts of purchasing fictitious invoices as a percentage

of the net invoice value, % 10.0 0.0Average monthly gross wage per person (HUF) 350,000 881,915

Wage supplement in cash 250,000 0 Total actual net wage income 440,000 440,000

Total costs of employment 746,978 1,179,306

GDP per employee in Hungary in,2006 (HUF thousand) 8,515 8,515

Number of employees 50 50

GDP per employee at the company relative to the national average

in Hungary in,2006, % 180.0 180.0Gross added value (GDP) 766,350,000 766,350,000

Total costs of employment/year 448,186,667 707,583,830

Net after-tax wage 114,000,000 264,000,000

Total contributions and taxes 167,520,000 443,583,830

Net value of the purchased fictitious invoices 166,666,667 0

Part of the revenue that remains after the deduction of costs

other than employment costs (net added value) 638,625,000 638,625,000

Payable VAT=VAT of the added value 127,725,000 127,725,000

Pre-tax profit 190,438,333 -68,958,830

Corporate income tax and solidarity tax 38,087,667 0

Profit and loss according to the balance sheet 152,350,667 -68,958,830

Dividend tax 38,087,667 0

Owner's withdrawal (taxed dividend) 114,263,000 0 Total contributions and taxes 371,420,333 571,308,830

GDP deficit=required loan from the owners 0 68,958,830 Required GDP 766,350,000 835,308,830







686

provide a loan to the company. This is non-sense! What is more, the net income and theshare it represents in the GDP is lower thanthat indicated in the table, since the modeldid not calculate with the four per cent soli-darity tax payable on the monthly gross salaryof HUF 881,915.

The fact that the entrepreneur should use hissavings or take out a loan in order to be able topay all taxes, beats even the 'clockwork withzero efficiency', a snappy metaphor coined byPéter Mihályi to illustrate that the tax system isnothing but an end in itself. “It is worth recall-ing Ferenc Jánossy's parable that he told in thewell-known debate of the Petõfi Circle in 1956on the relationship between the coal mines andthe power plants. The mines give coal to thepower plants, and in return the power plantsgive electricity to the mines. The then-existingHungarian situation was close to the extremepossibility when the mines with low efficiencyand the power plants with equally low efficien-cy served only each other. Thus, “the efficiencyof the entire clockwork is zero – concludedJánossy -, since it gives nothing to the externalworld”.” (Péter Mihályi, 2008)

ISSUERS OF FICTITIOUS INVOICES

It is known that the buyers mostly includeHungarian small and medium-sized entrepre-neurs, however foreign owned companies arealso engaged in more sophisticated ways of fic-titious invoicing. But who are the issuers of thefictitious invoices? When setting up the cate-gories I used my experiences gained whilestudying the SME sector for decades, as well asthe works of the staff members of the NationalBank of Hungary, Judit Krekó and Gábor P.Kiss. (See Table 7)

The table shows that tax payment can beevaded in two ways: either by using fictitiousinvoices, or by rendering performance withoutgiving an invoice. Under fictitious invoicing Imean the writing-off of private consumption ascosts, and part of the transfer prices of multi-national companies that result in taking theprofits produced in Hungary to countries withmore favourable tax rates. Untaxed incomewithdrawn with the help of fictitious invoicesforms part of the GDP observed by theHCSO, while non-invoiced performance istreated as non-observed economy (abbreviated

Table 7

TYPES OF TAX EVASION

Source: Judit Krekó- Gábor P. Kiss: Tax evasion and the Hungarian tax system, Institute of Economics, Hungarian Academy of Sciences,Seminars, 2008

1. Companies: tax-base reduction, accounting private consumption as costs2. Tax evasion by foreign owned companies (regrouping of incomes, e.g. through financing

and transfer prices)3. Concealment of capital income: on the basis of concealed entrepreneurial revenues (non-

invoiced performance)

Evasion of taxes on capitalincome

1. Concealment of employee incomes: illegal work, or under-declared wages (partial cash pay-ments)

2. Accounting of wage income as capital income (e.g. bogus contracts)

Evasion of taxes on wageincome

1. Concealed consumption through the connivance of the entrepreneur and the buyer (non-invoiced performance)

2. Concealment of imports3. Illegal VAT reclaim

VAT fraud


687

as NOE in international use) by economic sta-tistics. (Report of the committee examiningthe whitening of the economy, February 2008,www.mkt.hu,)

Money withdrawn with the help of fictitiousinvoices and the GDP produced by way ofnon-invoiced transactions go to the finalincome owner's pocket in the form of wageincome or capital income independent of thefact that the withdrawn income gets from thecompany to the private individual as a result ofa VAT fraud or in any other manner. The cate-gory of the given “black” income depends onthe disposition of the final income owner. Thefictitious invoice factories that return 90 percent of the net invoice value to the private indi-vidual representative of the recipient of theinvoice and get the VAT and 10 per cent of thenet invoice value in return, can dispose of 25per cent of the untaxed part of the GDP pro-duced by the invoice recipient if they do notpay the VAT to the state. This money is with-drawn from the banks by the bogus owners andmanaging directors of the invoice factories, andis transferred to the actual operator of the fic-titious invoice scheme for some compensation(labour income). The latter receives incomeunder both legal titles, since the invoice facto-ry is in fact his enterprise.

Clarifying the final position of the incomeowner in the different categories of fictitiousinvoicing is important because this is the onlyway to assess unrealised budget revenues. Theloss is different if someone gets illegal moneyas labour income, or in the form of capitalincome. (In the latter case the loss is muchless.) I would like to refer back to the index ofthe tax wedge: in the case of gross wage income(that includes taxes and contributions, too),the loss is 56 per cent, while in the case of cap-ital income, which includes the corporateincome tax and the dividend tax, the loss is 40per cent. The actual size of unrealised budget-ary revenues can be obtained by quantifying

the tax wedges of illegal incomes based on theestimates. In other words, we answer the fol-lowing question: How would the final incomeowners and the state have shared the illegallyproduced GDP if all taxes and contributionshad been paid? (See Table 8)

However, it is worth examining the virtualloss of the state, since the comparison of theactual and virtual losses may lead to conclu-sions indispensable for freeing the hamstrungeconomy. In my opinion virtual budgetary loss-es can be obtained if we consider the entire ille-gal income net, and we calculate the accompa-nying taxes and contributions conversely. Iwould also like to remind you that taxes andcontributions account for one and a half or twotimes the net wage income, while the dues onthe net capital income equal 60 per cent.

Before analysing the correlations betweenthe actual and virtual losses, let us consider thedifferent types of fictitious invoicing.

Classic invoice factories

Bogus or fictitious companies in the sense thattheir owners and managing directors are inac-cessible for the authorities (foreigners, home-less people, etc.), or even if they are accessible,they have no enforceable assets with which thedamage caused could be reimbursed. In aninvoice factory the money paid for the invoiceis withdrawn, wherefore it has deficits in itsbooks, and consequently it must vanish intothin air. This means that since the authoritiescannot find the company at its registered officeand both the managing directors and ownersare inaccessible, the court of registration willdelete the company from the company register,and the company will sooner or later be liqui-dated. The tax arrears of a company with noassets cannot be collected, and the owners andmanagers thereof can be convicted only in atiresome process. Anyway, fictitious invoicing


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is sanctioned rather mildly, and the corporateprocedural rules – although they have becomemuch stringent – still allow for establishingsuch firms and making them bogus. The num-ber of liquidations is extremely high inHungary. Although investigating this fact doesnot belong to the scope of this study, we can-not be wrong if we say that it can be explainedwith the large number of invoice factories. Thereal invoice factory operators know it well:their operational risk is reduced if their factoryfunctions only for a short time, after whichthey let it go down the drain and establish anew company.

“The commissioning companies, whichreduced their tax bases with the help of theinvoice factory, signed a contract with one ofthe bogus companies owned by István Sz.and his partners, and then, “after the workwas completed”, transferred the cost of thework. The recipient company transferred theamount right away to another (intermediary)bogus company, and that company to a thirdone, the “managing director” of which with-drew the money in cash. The role of the mid-dlemen ended here. Sz. and his accomplicesdeducted the “fees” they were eligible for,and returned the rest of the money to themanagers and owners of the commissioningcompany. According to the data of theNational Bureau of Investigation, in the pasttwo years more than HUF 3 billion was with-drawn in cash from the accounts of the fiftycompanies under inspection”. (Attila Gy.Fekete, 2007)

The invoice is usually issued for a fictitiousactivity the performance of which is difficultto be checked by the authorities: earthworks,education, consultancy, cleaning, advertising,etc. Since anti-money laundering legal regula-tions have become more stringent, the risk ishigher when withdrawing higher amounts ofcash from the banks. Sooner or later regularwithdrawals become suspicious, which is

another cause for establishing newer andnewer companies.

The primary buyers of invoice factory prod-ucts are entrepreneurs that are forced to run atwo-channel wage system, wherefore most ofthe money equalling the countervalue of theinvoice and withdrawn in cash is wage income.From the GDP of HUF 300 billion that –according to my estimates – reaches the finalrevenue owner through the invoice factoriesuntaxed, at least HUF 160 billion should bepaid to the state. However, due to the low levelof productivity, its enforceability is very ques-tionable. On paper hundreds of thousands ofpeople live only a little over the subsistencelevel just because they do not pay taxes on asignificant portion of their net income. Thesize of the state's virtual losses (HUF 400 bil-lion) represents the deficit in the GDP the pro-duction of which would be necessary to pay thetaxes on the net incomes. The illegal institutionof fictitious invoicing can be eliminated onlywith significant economic growth!

Companies paying the simplifiedentrepreneurial tax

By paying the simplified entrepreneurial tax,which currently equals 25 per cent of the grossrevenues, the enterprise redeems all other taxes(provided the contribution payment obliga-tions are fulfilled in another legal relationship.)When introduced, this apparently low rate taxseemed to be beneficial, but in fact it takesmore away and gives less to the state. The factis that a lot of companies paying the simplifiedentrepreneurial tax bind their extra capacities(the gross revenue potential between the actu-al turnover and the upper limit of HUF 25 mil-lion) with fictitious invoices. For a commissionthey help peer companies withdraw moneywithout paying taxes, practically at no risk.Since the simplified entrepreneurial tax related


689

to the fictitious invoices is paid, the tax author-ity is no longer interested in investigating thefact of fictitiousness, its capacities are absorbedby other activities that are deemed to be moreimportant.

In 2007 as much as HUF 152 billion waspaid as simplified entrepreneurial tax. It iseasy to calculate that last year the grosssales revenues of companies paying the sim-plified entrepreneurial tax evidently exceed-ed HUF 600 billion. If we assume that onefourth of it – HUF 150 billion – was usedfor the withdrawal of income produced inother enterprises, mostly as wage income,then the virtual loss of the state exceeds theamount that the state could collect fromthis tax type.

However, the ratio of income withdrawnwith the help of invoices from companies pay-ing simplified entrepreneurial tax is ratherunderestimated. This tax type (and the lack ofrisks in the concomitant fictitious invoicing),as well as the tax exemption of the minimumwage played a key role in that the two-channelwage system could become a general practicein the SME sector. “Although earlier therewere some conflicts between the employerand the employee regarding the wages, todaythere is full agreement about the fact – in allcompanies but the Hungarian subsidiaries ofseveral hundreds of multinational companies –that the entrepreneur and his employee (thetwo are often the same person) can peacefullycoexist by setting the ratio of declared incomeand cash payments right.” (István Csillag,2008)

István Csillag's lamentation is justified, yetunpleasant, since he was a member of the gov-ernment that introduced the tax exemption ofthe minimum wage and the simplified entrepre-neurial tax, and thus legalised the two-channelwage system instead of implementing a taxreform adequate for the performance of theSME sector.

Companies engaged in non-invoicebased activities that are compelled toshow expected revenues

Under the increasingly stringent tax rules – firstof all under the threat of wealth gain investiga-tions – more and more companies that generaterevenues without issuing invoices are compelledto make sure that they present a turnoveracceptable by the tax authority. However, thisgoal is mostly achieved by selling fictitiousinvoices and not with real transactions. Theaccountant of the seller and the buyer is usuallythe same person or company. The accountantcoordinates the process, he/she knows whichclient has failed to issue enough invoices, andwhich client needs to receive invoices. Thecompanies make sure to pay the VAT. This formof fictitious invoicing is practically risk-free,since no tax auditor could reveal the fictitiousnature of such transactions.

The issuer of the fictitious invoice still doesnot need to enter the real turnover in hisbooks, while he can deduct costs and on top ofthat he can make money on the transactions.The buyer of the invoice does not need toworry either, since the origin of the funds sowithdrawn is known only to the accountantand the seller. And apart from getting extraearnings, the accountant ties his clients to him-self/herself with these confidential services.

I assume that this form of fictitious invoic-ing is also mainly used for withdrawing wageincomes, and therefore the state incurs heavylosses. It is practically impossible to fightagainst it successfully, since the strong interestsshared by the entities involved cover thescheme with an unpenetrateable shield.

Off-shore companies

Earlier off-shoring was exclusively used by for-eign owned companies with developed tax


690

planning schemes. However, today an increas-ing number of Hungarian owned companiesallow themselves the “luxury” of having a sup-plier or owner registered in a tax heaven. Thesupply performance of off-shore companies isoften completely fictitious, the value of theinvoices they issue is often transferred to abank account that ensures full anonymity forthe actual owners, and from which the finalowner can receive wage or capital income withminimum losses.

“Magyar Telekom is unable to present theannual report and the audited balance, becauseits auditor, the international auditing companyPriceWaterhouseCoopers (PWC) is not willingto countersign it. Instead, the auditing compa-ny launched a proceeding against a subsidiaryof the company, Telekom Montenegro, in con-nection with two consultancy contracts havinga total value of HUF 700 million, which weresigned irregularly according to the auditingfirm. According to media information, themoney spent on market research contractscould have been transferred to off-shore com-panies. What is more, the contract itself wassigned with an off-shore company: it is possiblethat the paid amounts are not proportionate tothe work performed, but the case may alsoinvolve the payment of lobby funds or tax eva-sion.” (Index, 2006)

While earlier off-shore companies represent-ed a tool for withdrawing capital income, todaythey are increasingly used for hiding wage-income type funds from the tax authorities.Due to the lax accounting discipline of compa-nies registered in tax heavens, the banking cardsof off-shore companies can be used for payingfor private consumption in Hungary and abroadalike, for withdrawing cash and accounting it ascosts with fictitious invoices. The institution ofoff-shore companies practically questions thepoint of wealth gain investigations. However,the fight against it requires international coop-eration across the continents. The European

Commission wants to become the engine ofthis fight. “In his statement given to Austriannewspapers, László Kovács also said that as aresult of the tax conflict between Germany andLiechtenstein, he would submit to theCommission the expert opinion describing thenew interest tax directive – which also address-es the issue of how tax embezzlements could becombated more efficiently – sooner thanplanned, already in May instead of the end ofthe year.” (NAPI Online, 2008)

Multinational companies that withdrawincome exceeding the equitable profitmargin by incorporating such incomeinto the transfer prices

Invoicing among the subsidiaries of multina-tional companies is a favourite target of the taxauthorities. Although the methodology ofinspections has been significantly refined, for-eign owned companies can still significantlyregroup their revenues by exploiting the possi-bilities inherent in this invoicing practice, andtake such revenues into countries that have themost favourable tax rates. A considerable partof the profit generated in the subsidiary isincorporated into the transfer prices, and istaken out of the country by transforming itinto account carrying charges, often into taxheavens, where practically no tax has to be paidon such income. The entirety of this incomerepresents untaxed capital income. Since com-panies that take profit out of the country donot pay dividend taxes in Hungary, they can“only” save on the corporate income tax: theestimated savings of HUF 100 billion also leadto a significant deficit in the state budget.

Apart from applying the complicated systemof transfer prices efficiently, foreign ownedcompanies do not despise using more aggres-sive tools of tax optimisation, such as invoicefactory services.


691

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692

“Between 2001 and 2005 the Hungarian sub-sidiary of Siemens transferred over HUF 800million to seven bogus companies owned byhomeless people that allegedly provided consul-tancy services to various divisions of the group.The consultancy companies that in fact provid-ed no such services at all were organised andhired by András Zoltán Schrödtl for the medicaltechnology, IT, energy and building automationdivisions of Siemens.” (SG.hu, 2007)

Writing off private consumption as corporate costs

All types of enterprises – small, medium-sizedand large companies alike – are over-inclined touse this form of fictitious invoicing. The risk islow, and in case they are caught, they must onlypay the missing part of the corporate incometax. Yet, this form causes as much damage asthe other types of fictitious invoicing. It alsoinvolves that money that could be legally with-drawn only as after-tax wage or capital incomeis spent on private consumption without pay-ing taxes. If the taxes on this consumptionwere paid, only a significantly smaller portionof the products and services accounted couldbe purchased.

This form of fraud is primarily used forwithdrawing wage type income, too, whichcauses significant damage to the state budget.Although the efficiency of tax legislation hasimproved a lot since the introduction of taxeson vehicles and telephone services used for pri-vate purposes, there is not much chance forfurther confining this method of fictitiousinvoicing. Partly because it requires dispropor-tionately great efforts from the tax inspectorsto prove private consumption, and also becausethe extension of normative taxation to otherprivate purpose services and products wouldput disproportionately large administrativeburdens on the enterprises.

I assume that each year the six modes of fic-titious invoicing puts a GDP of HUF 1,500 bil-lion into private pockets without paying taxes,more or less evenly distributed between labourand capital incomes. The actual loss of the stateis around HUF 600 billion, while the virtualloss equals the amount of the income takenabroad. In other words, this much GDP shouldbe generated in excess so that the final incomeowners could peacefully enjoy spending oraccumulating their income that they got holdof with various tricks. (See Table 9)

I assume that a smaller portion of the hiddenHungarian economy is covered by fictitiousinvoices. The larger part of untaxed GDP isstill produced in transactions in which noinvoices are issued. Most of the income fromnon-invoiced transactions is spent as wageincome, in an amount of HUF 1,000 billion peryear according to my estimates. Due to non-invoiced transactions the state is deprived fromrevenues over HUF 800 billion.

In the table I tried to assess the volume ofthe Hungarian hidden economy: a GDP ofHUF 3,300 billion – i.e. around 13 per cent ofthe official GDP – is not taxed at all. My esti-mates correspond to those of others, for exam-ple the estimates of Csák Ligeti, the acknowl-edged expert of the issue (Csák Ligeti, 2007)Approximately half of the untaxed GDP isblack money used as wages, and the other halfis capital income. Every year the state suffersan actual loss of HUF 1,500 billion. If only halfof this amount could be collected, theHungarian budget would have considerablyless headache. But how much of this amountcan we realistically expect to be collected bytightening the tax system?

Well, not too much. The report of the com-mittee in charge of examining the whiteningof the economy (www.mkt.hu) shows that in2007 the budget realised nearly HUF 80 bil-lion more revenues due to measures taken forthe whitening of the economy, including the


693

increase in the staff of the Hungarian Tax andFinancial Control Administration, the extracosts of which total HUF 7 billion a year.Compared to the fact that the state is deprivedof an annual tax revenue of around HUF1,500 billion, the collection of a net amount ofHUF 73 billion is precious little. But it isimpossible to have companies pay more aslong as the wage related dues are not adjustedto reality. As we could see from the previouschapters the income producing ability of theHungarian enterprises is so low that they areunable to produce as much GDP as would benecessary for the payment of all taxes andcontributions. They are forced to commitfraud.

I do not undertake to estimate what portionof the illegally distributed income comes fromnecessity frauds, and what portion could bepaid swimmingly by those enjoying it.However, as I stressed in my analysis of thegroups engaged in fictitious invoicing, thereare forms that are increasingly used by thoseentities whose tax-paying potentials are wellabove the Hungarian average. On the otherside, though, the fictitious invoicing schemesthey apply can hardly be controlled by theauthorities. The duality of the Hungarianeconomy leaves its mark on the black econo-my, too. On one side there are hundreds ofthousands of necessity tricksters from whomno more taxes can be collected. On the otherthere are the entities that could pay the taxes,yet they have the opportunity to evade themin part or in full.

The amount of collected taxes cannot con-siderably be increased merely by tighteningthe tax rules. In addition to the application ofstricter sanctions against tax evaders, the taxrates must be concurrently reduced for thesignificant whitening of the black economy. Inreturn, budgetary revenues in the law-abidingsectors will obviously decrease due to thereduced tax rates. To avoid the concomitant

problems, cuts must be enforced on theexpenditure side and/or lost revenues must bemade up for by other taxes. Precarious balanc-ing can be avoided if we focus on the virtualrather than on the actual losses. According tothe estimates of Table 9, if we consider theentire income distributed in the black econo-my net – and that is what it is – the stateincurs a virtual loss of HUF 3,500 billion.However, the related margin is missing fromthe Hungarian GDP. What would happen ifthe new economic policy focused on the fol-lowing issue: How to work off this virtual lossas much as possible, in other words, how toencourage enterprises to produce more GDP?In the following we are looking for theanswers to this question.

AFFORDABLE AND EQUITABLE TAX RATES

The fundamental statement of this study is thatin the current tax system Hungarian companieswith low levels of productivity are unable tohonestly pay all taxes. The use of the two-chan-nel wage system, in which employees receivepart of their wages untaxed, in cash, hasbecome wide-spread. Hundreds of thousandsof people (entrepreneurs and employees alike)are forced to commit fraud on a continuousbasis in order to make both ends meet. Theyare able and willing to meet their tax paymentobligations only under the lighter two-channelwage system. Let us see a tax system in whichthe tax rates would more or less correspond tothis light burden, i.e. taxpayers would not beforced to cheat. (See Table 10)

The proposed tax system is a flat-rate sys-tem: both the PIT and the corporate incometax would be 15 per cent. Contributions wouldalso be significantly reduced by 6.5 per cent(employer's contributions) and 7 per cent(employee contributions), respectively. The


694

dividend tax would remain the same, howeverthe VAT would again be raised to 25 per cent,in part to offset reduced tax revenues. Tax cred-its and the flat-rate healthcare contributionwould be abolished. The tax system wouldbecome much more simple and transparent.(The drop in tax revenues collected from thesectors that pay all taxes – which arises fromthe alleviation of wage related dues – should beoffset by the introduction of new tax types tobe described in detail in the next chapter.)

Table 11 compares the dues payable on theaverage wages at Company A in the two-chan-nel wage system, as well as with the new tax andcontribution rates. In the two-channel systemthe company ensures an average net wage of

HUF 149,115 by giving the employee a grossmonthly wage of HUF 140,000, and HUF50,000 in cash. The operation of this systemcosts the company HUF 244,406 each month.If the company paid all taxes related to the netwage, it would need to give a gross wage of

HUF 263,011 to an average employee, and thetotal costs involved would be HUF 353,069.This is exactly why the company is forced toapply the two-channel wage system, since if theextra tax burden of HUF 108,664 was paid, theentrepreneur would have no profits, not tomention funds for investments and develop-ment.

In the new tax system the same net incomecould be ensured with the disbursement of agross wage of HUF 198,820. This would prac-tically cost not more than the maintenance ofthe two-channel wage system, and the entre-preneur and the employee would not be com-pelled to connive and commit fraud. Theywould be able and willing to pay the taxes. Whywould they cheat if they had the same amountof money with all taxes paid as in the case offictitious invoicing?

Of course, the state incurs some loss, butonly compared to the ideal situation in whichthe company pays all taxes and contributions.

Table 10

A POSSIBLE FLAT-RATE TAX SYSTEM(per cent)

Fully taxed wages Reducedat the current rates rates

PIT tax rate, if the annual gross wage is less than HUF 1,700.000 18.0 15.0

PIT tax rate, if the annual gross wage is more than HUF 1,700.000 36.0 15.0

Employee contributions 17.0 10.0

Pension contribution 9.5 6.0

Healthcare contribution 6.0 4.0

Employee contribution 1.5 0.0

Tax credit/month (HUF) 11,340 0

Contributions payable by the employer 33.5 27.0

Pension contribution 24.0 20.0

Healthcare contribution 5.0 7.0

Employers taxes 3.0 0.0

Vocational training contribution 1.5 0.0

Flat-rate healthcare contribution (HUF) 1,950 0

Corporate income tax and solidarity tax 20.0 15.0

Dividend tax 25.0 15.0

VAT 20.0 25.0


695

This loss is virtual, since the missing tax rev-enues are not paid especially because the com-pany is unable to produce the GDP that wouldserve as a margin. What is more, the statewould receive more in the new system than inthe two-channel one, since the company wouldpay more taxes instead of paying commissionsto the issuers of fictitious invoices. In the two-channel system Company A pays a total ofHUF 89,735 to the state after an averageemployee, and would pay HUF 103,386 in thenew system each month!

In the new tax system the tax wedge ofemployment would be 40.9 per cent, i.e. practi-cally the same as the current tax wedge of cap-ital income. This is a rate that is equitable andaffordable for the Hungarian enterprises.

Although illegal, the two-channel wage systemcould spread so widely because the burden onHungarian enterprises became bearable onlythrough this system.

Let us see how the GDP produced byCompany A would be distributed in the newtax system. The first three columns of the sixcolumns presented in Table 12 shows the distri-bution of the GDP produced by Company A inthe two-channel wage system, with all currenttaxes paid, as well as under the new tax system.The other three columns show what wouldhappen if productivity improved by 10 percent, if employment grew at the same rate, andif net wages increased by 5 per cent as a resultof the new tax rates.

In the new system the distribution of the

Table 11

THE COSTS OF EMPLOYMENT IN THE NEW SYSTEM AT COMPANY A

Two/channel Fully taxed REDUCED TAXwage system wages at the rates

current rates

Average monthly gross wage per person (HUF) 140,000 263,011 198,820

Dues payable by the employee 23,800 44,712 19,882

Tax credit 8,115 0 0

Actual PIT 17,085 69,184 29,823

Actual PIT rate 12.2% 26.3% 15.0%

Net wage 99,115 149,115 149,115

Wage supplement in cash 50,000 0 0 Total actual net wage income 149,115 149,115 149,115

Contributions payable by the employer 48,850 90,059 53,681

Net value of fictitious invoices required for the with-

drawal of cash to be given as wage supplement 55,556 0 0

Costs of purchasing fictitious invoices 5,556 0 0

Actual dues payable by the employer 104 406 90,059 53,681 Total costs of employment 244 406 353,069 252,501

Structure of the employment costs, % 100.0 100.0 100.0

Total net wage income, % 61.0 42.2 59.1

Total dues, % 39.0 57.8 40.9

Contributions and taxes, % 36.7 57.8 40.9

Costs of cash withdrawal, % 2.3 0.0 0.0


696

same amount of GDP would be in line with theincome relations that emerged in the two-chan-nel system. The only difference is that theentrepreneur's share would somewhat decreaseand the state's share would somewhat increase.This is not good at all, since the deduction rateof 50 per cent is still much too high. No fundswould remain for depreciation, investmentsand development. And the entrepreneur's prof-its seem small even in absolute terms. In fact,the taxes on capital income should be reducedeven more at the expense of the state's share,and perhaps it would be better to keep the cur-rent VAT rate!

The table shows that compared to the two-channel system, state revenues would grow,albeit to a small extent only. Naturally, theamount of taxes and contributions payable inthe new system would fall short of the valueindicated in the second column (What wouldhappen if all dues were paid?). The difference isHUF 14 million, however since the GDP thatwould serve as a margin is also missing, compa-nies could not pay this amount even if theywanted to! This is the so called virtual deficitthat Hungarian enterprises must reduce afterbeing freed from the hamstrung situation. Inreturn for the equitable taxes, the HungarianSME sector must improve its performance byreleasing the suppressed energies.

The last three columns of the table examinethe impacts of possible performance improve-ment under the conditions of the new tax sys-tem.

If productivity improved by 10 per cent,and the number of employees and the averagewage would remain unchanged, the gross addedvalue produced by Company A would increaseby nearly HUF 6 million. The surplus would beshared by the state and the enterprise. Tax rev-enues will reach the middle value between therevenues realised from the current two-channelsystem, and the tax revenues expected but notrealised with the current tax rates (since the

companies cannot afford to pay such hightaxes). With tax rates adjusted to this sector,these small and medium-sized companies couldwork off almost half of the virtual budgetdeficit they are responsible for. They should donothing “but” improve their productivity byten per cent! Is it an impossible task? I don'tthink so! The only thing to do is to work a lit-tle harder, in a more disciplined and organisedmanner, make better use of the existing endow-ments, and productivity will perceivablyimprove. The feeling of getting free from thehamstrung situation will evidently make thishappen!

If at this productivity level, but withunchanged wages the company would employ10 per cent more employees, a significant por-tion of the virtual tax deficit could be workedoff from the surplus GDP created. The tax rev-enues would almost equal the amount that thestate – vainly – expects with the current taxrates. A lot of entrepreneurs do not have moreemployees only because they find it too riskyto continuously ensure the conditions formaintaining the two-channel wage system for alarger staff. Instead, they keep their perform-ance low. An inspiring environment can put anend to this suppression, and the companies canincrease their staff practically without invest-ment projects. In the SME sector improvingproductivity by 10 per cent and increasingemployment by 10 per cent would be sufficientto ensure much higher tax payments in the newtax system than in the existing one! For thetime being, with the two-channel wage systemin place, the amount of taxes actually paid byCompany A is below HUF 50 million.However, with a slight growth in employmentand productivity alike the state could realiseover HUF 60 million in tax revenues. Not tomention the other benefits that the state couldenjoy through the employment of tens ofthousands of job seekers.

The last column of the table shows what


697

Tabl

e 12

DIST

RIBU

TION

OF

THE

GDP

PROD

UCED

BY

COM

PANY

A

TTw

o-ch

anne

lFu

lly ta

xed

Redu

ced

tax

Prod

uctiv

ityEm

ploy

men

tNe

t w

age

syst

emw

ages

at t

hera

tegr

owth

grow

thw

age

curr

ent r

ates

grow

th

Aver

age

mon

thly

gro

ss w

age

per p

erso

n (H

UF)

140,

000

263,

011

198,

820

198,

820

198,

820

208,

761

Wag

e su

pple

men

t in

cash

50

000

0 0

0 0

0 To

tal a

ctua

l net

wag

e in

com

e 14

9,11

5 14

9,11

5 14

9,11

5 14

9,11

5 14

9,11

5 15

6,57

1 To

tal c

osts

of e

mpl

oym

ent

244,

406

353,

069

252,

501

252,

501

252,

501

265,

126

The

grow

th ra

te o

f net

wag

es a

t the

com

pany

, %

0.0

0.0

0.0

0.0

0.0

5.0

The

grow

th ra

te o

f pro

duct

ivity

at t

he c

ompa

ny, %

0.0

0.0

0.0

10.0

10

.0

10.0

Th

e gr

owth

rate

of e

mpl

oym

ent a

t the

com

pany

, %

0.0

0.0

0.0

0.0

10.0

10

.0

GDP

per e

mpl

oyee

in H

unga

ry in

,200

6 (H

UF th

ousa

nd)

8,51

5 8,

515

8,51

5 8,

515

8,51

5 8,

515

Num

ber o

f em

ploy

ees

20

20

20

20

22

22

GDP

per e

mpl

oyee

at t

he c

ompa

ny re

lativ

e to

the

natio

nal

aver

age

in H

unga

ry in

,200

6, %

60

.0

60.0

60

.0

66.0

66

.0

66.0

Gr

oss

adde

d va

lue

(GDP

) 10

2,18

0,00

0 10

2,18

0,00

0 10

2,18

0,00

0 11

2,39

8,00

0 12

3,63

7,80

0 12

3,63

7,80

0 To

tal c

osts

of e

mpl

oym

ent/y

ear

58,6

57,3

33

84,7

36,6

09

60,6

00,3

36

60,6

00,3

36

66,6

60,3

70

69,9

93,3

88

Net a

fter-t

ax w

age

23,7

87,6

00

35,7

87,6

00

35,7

87,6

00

35,7

87,6

00

39,3

66,3

60

41,3

34,6

78

Tota

l con

tribu

tions

and

taxe

s 21

,536

,400

48

,949

,009

24

,812

,736

24

,812

,736

27

,294

,010

28

,658

,710

Ne

t val

ue o

f the

pur

chas

ed fi

ctiti

ous

invo

ices

13

,333

,333

0

0 0

0 0

Part

of th

e re

venu

e th

at re

mai

ns a

fter t

he d

educ

tion

of c

osts

oth

er th

an e

mpl

oym

ent c

osts

(net

add

ed v

alue

) 85

,150

,000

85

,150

,000

81

,744

,000

89

,918

,400

98

,910

,240

98

,910

,240

Pa

yabl

e VA

T=VA

T of

the

adde

d va

lue

17,0

30,0

00

17,0

30,0

00

20,4

36,0

00

22,4

79,6

00

24,7

27,5

60

24,7

27,5

60

Pre-

tax

prof

it 26

,492

,667

41

3,39

1 21

,143

,664

29

,318

,064

32

,249

,870

28

,916

,852

Co

rpor

ate

inco

me

tax

and

solid

arity

tax

5,29

8,53

3 82

,678

3,

171,

550

4,39

7,71

0 4,

837,

481

4,33

7,52

8 Pr

ofit

and

loss

acc

ordi

ng to

the

bala

nce

shee

t 21

,194

,133

33

0,71

3 17

,972

,114

24

,920

,354

27

,412

,390

24

,579

,324

Di

vide

nd ta

x 5,

298,

533

82,6

78

2,69

5,81

7 3,

738,

053

4,11

1,85

8 3,

686,

899

Owne

r's w

ithdr

awal

(tax

ed d

ivid

end)

15

,895

,600

24

8,03

5 15

,276

,297

21

,182

,301

23

,300

,531

20

,892

,426

To

tal c

ontri

butio

ns a

nd ta

xes

49,1

63,4

67

66,1

44,3

65

51,1

16,1

03

55,4

28,0

99

60,9

70,9

09

61,4

10,6

96

Dist

ribut

ion

of th

e gr

oss

adde

d va

lue,

%

100.

0 10

0.0

100.

0 10

0.0

100.

0 10

0.0

Taxe

s an

d co

ntrib

utio

ns, %

48

.1

64.7

50

.0

49.3

49

.3

49.7

To

tal n

et w

age

inco

me,

%

35.0

35

.0

35.0

31

.8

31.8

33

.4

Owne

r's w

ithdr

awal

, %

15.6

0.

2 15

.0

18.8

18

.8

16.9

Co

mm

issi

ons

paid

to fi

ctiti

ous

invo

ice

issu

ers,

%

1.3

0.0

0.0

0.0

0.0

0.0


698

impact it would have on the distribution of theadded value if the average net wage of theemployees was raised by five per cent given theincreased staff and level of productivity. If weexpect better work, we must pay more for it.Since higher wages also imply higher tax rev-enues, this restructuring of the wage systemwould obviously be detrimental to capitalincome despite the fact that – as we havestressed several times – the portion thatremains in the entrepreneur's hands wouldremain low even in this new tax system. Inaddition to the owner's profits, much of thegross added value should be available forinvestments and development (not to mentionthe local business tax and the banking costs).

However, raising the ratio of net wageincome is also a fundamental condition for eco-nomic growth. The income distribution thatoccurs given the favourable tax rates stillfavours the state in the case of Company A. Itsshare of 50 per cent is still too high! What ismore! This ratio even exceeds the nationalaverage. Although it is not easy to accessnational data in this structure, and only 2005figures are available, I managed to present thatthe sum of the revenue side of the budget(HUF 6,896 billion) and the paid social securi-ty contributions (HUF 3,266 billion) withwhich all tax and contribution categoriesincluded in the model can be compared equals46 per cent of the GDP (HUF 22,055 billion).This seemingly favourable value can also beattributed to the dual structure of theHungarian economy. In the case of Hungariancompanies with low levels of productivity theratio of state deductions remains high even atfavourable tax rates. At the same time, in thecase of added value produced by foreign ownedcompanies that demonstrate outstanding pro-ductivity, state deductions represent a smallratio even at the current, high tax rates.

We are going to prove our statement with theincome relations of the foreign-owned

Company C. (See Table 13) In the companythat employs 1,000 people for an average grosswage of HUF 250,000, the productivity levelper employee is twice the national averagemeasured in 2006 (on the basis of Zoltán Pitti'sfigures). The company can easily meet its taxpayment obligations even at the current taxrates (it pays all the wage related dues, howeverit does not need to pay dividend tax, since thefinal owner of the capital income pays it in hishome country, or – save the mark! – in an off-shore heaven), and plenty will be available forthe owners, too. It must be admitted thoughthat the share of the employees' net wages islow – this is what high productivity means. Theratio of state deductions from the gross addedvalue produced by the company is low: merely42 per cent, a really ideal ratio. Since the biggerpart of the Hungarian GDP is produced by for-eign owned companies, it is understandablehow the ratio of state deductions can stay below50 per cent at macro-level, while in the case ofHungarian owned companies this value is wellabove this critical level due to the low incomegenerating ability of such companies.

The table also shows what would happen ifCompany C also paid taxes according to thenew conditions. It is shocking, and is also verypositive from our point of view that the taxes ofCompany C would hardly decrease. Althoughthe dues on wages would drop by around HUF800 million, this would be almost offset by asurplus VAT payment of nearly HUF 600 mil-lion. The amount of taxes payable by the largetax-payer multinational companies would notfundamentally decrease in the new tax system!

One can draw further noteworthy conclu-sions regarding the dividend tax by analysingthe correlations of the table. If they take thedividends they produce in Hungary abroad, for-eign owned companies are exempted from pay-ing the dividend tax in Hungary in accordancewith the international treaties. At any rate, thedividend tax would total HUF 2 billion in the


699

case of Company C. If this tax was paid, thededuction rate would exceed 50 per cent even inthe case of Company C under the current taxrules. This fact means that on one hand it wouldbe a large burden for multinational companies,too, if they had to pay all taxes. On the otherhand they have a significant competitive edgeover Hungarian owned companies that canavoid paying this tax type only by fraud.

NEW TAX SYSTEM, REASONABLYREFORMED BUDGET

In the first chapter we modelled the impacts ofa new tax system in which the personal incometax would be a flat-rate tax, and would equal 15

per cent, just like the corporate income tax.Wage related dues would decrease by 13.5 percent. The dividend tax would remain the same,the solidarity tax would be abolished, howeverthe VAT would again be raised to 25 per cent,and a new tax type, the wealth tax would beintroduced.

The results of the simulation show that theHungarian SME sector, which protects itselffrom the excessive tax burdens compared to itsproductivity by applying the illegal two-channelwage system, would not pay less taxes at ratesensuring bearable tax burdens (similar to thoseachieved by fictitious invoicing) than today. Whatis more, if they did not have to use a significantpart of their energies to mitigate the risks of fraudinstead of using them for the creation of condi-

Table 13

DISTRIBUTION OF THE GDP OF THE FOREIGN OWNED COMPANY C

Fully taxed wages Reduced rates

Average monthly gross wage per person (HUF) 250,000 250,000

Number of employees 1,000 1,000

GDP per employee at the company relative to the national

average in Hungary in,2006 200.0% 200.0% Gross added value (GDP) 17,030,000,000 17,030,000,000

Total costs of employment/year 4,028,400,000 3,810,000,000

Net after-tax wage 1,716,000,000 2,250,000,000

Total contributions and taxes 2,312,400,000 1,560,000,000

Net value of the purchased fictitious invoices 0 0

Part of the revenue that remains after the deduction of costs

other than employment costs (net added value) 14,191,666,667 13,624,000,000

Payable VAT=VAT of the added value 2,838,333,333 3,406,000,000

Pre-tax profit 10,163,266,667 9,814,000,000

Corporate income tax and solidarity tax 2,032,653,333 1,472,100,000

Profit and loss according to the balance sheet 8,130,613,333 8,341,900,000

Dividend tax 0 0

Owner's withdrawal 8,130,613,333 8,341,900,000 Total taxes and contributions 7,183,386,667 6,438,100,000







700

tions ensuring better performance, companies inthis sector would pay a lot more taxes!

At the same time, the highly productivemultinational companies that honestly pay alltaxes on the employees' wages would not payless tax either. The surplus VAT collected dueto the higher VAT rate can offset the loss in taxrevenue due to the reduction of the personalincome tax rates and the contributions.

Let us see what impact the new tax systemwould have on the different tax types!

Wage related taxes and contributions

In 2007 the average monthly gross wage of anemployee was HUF 185,004, and the numberof employees totalled 2,760. In our model weexamined the taxes on this average wage in thecurrent and the new system. (See Table 14)

In the last column of the table we presentedthe differences between certain items of thetwo tax systems, projected on all employeesand one year. It can be seen that at macro-levelsavings of almost HUF 500 billion are achievedin the costs of employment. Although part of itwill be used to meet the increased VAT obliga-tion, the rest will be the token of rapid eco-

nomic growth. Entrepreneurs will be able touse those funds for development and invest-ments, i.e. to ensure the pillars of growth.

The net income of employees will grow bynearly HUF 9 billion. Although the higher VATwill drain some of this money, but the remain-ing sum is indispensable for three reasons.

The growth in the internal demand forthe products and services of the SME sector isan elemental condition for the rapid develop-ment of the companies operating in this sector.I would like to remind you of the fact that ifproductivity and employment grew just a little,the amount of taxes and contributions paid bythe SME sector could hit historical highs!

The net income of the population is allthe more necessary, since the volume of non-invoiced transactions will drop only if peoplecan afford to pay the prices that also includethe reduced taxes. This is an indispensable pre-condition for ensuring tax payment discipline,which calls for mandatory invoicing.

The increased share of wage incomesfrom the GDP is also an indispensable require-ment for the badly needed budget reform. Co-payment for public services (healthcare, educa-tion, etc.) is equitable only if the populationhas surplus income. The extra income is also a

Table 14

DUES PAYABLE ON THE AVERAGE MONTHLY WAGE

Fully taxed Fully taxed Difference per Difference forwages at the wages at the employee all employeecurrent rates net rates (HUF) (HUF billion/year)

Average monthly gross wage per

person (HUF) 185,004 185,004 0 0

Dues payable by the employee 31,451 18,500 12,950 428,913

Tax credit 0 0 0 0

Actual PIT 41,101 27,751 13,351 442,180

Actual PIT rate, % 22.2 15.0 0 2

Net wage 112,452 138,753 –26,301 –-871,093

Contributions payable by the

employer 63,926 49,951 13,975 462,861 Total costs of employment 248,930 234,955 13,975 462,861


701

precondition for expanding the unavoidableinstitution of mandatory pension.

According to the table, nearly HUF 450 bil-lion less will be realised in PIT revenues, andthe contributions paid will drop by almostHUF 900 billion. In 2007, the state yieldedHUF 1,820 billion from PIT, and (in 2005) ityielded HUF 3,226 billion from social securitycontributions. One third of these revenuesmust be made up for! As we could see, in thecase of the multinational Company C the VATsurplus can practically offset the reducedamount of PIT and contribution revenues, and,as we will see, the VAT surplus will be signifi-cant at macro-level, too.

However, part of the deficit of over HUF1,200 billion exists only virtually. The reasonbehind this is that real savings are realised inthe personal income taxes and contributions ofemployees working in the budgetary sector, i.e.they do not need to be collected! (In this sec-tor the wages and contributions of the employ-ees are covered from the taxes paid by the com-petitive sector.) Table 15 shows the savings.

In 2007, the budgetary sector employed748,000 people at an average monthly grosswage of HUF 206,307.

Altogether taxes of HUF 450 billion do notneed to be collected, because less PIT and con-

tributions should be paid for budgetary employ-ees in the new system! The actual tax and con-tributions deficit equals HUF 800 billion.

VAT

In 2007, budget revenues collected from VATwere HUF 20 billion shy from HUF 2,000 bil-lion. If the upper VAT rate was raised from 20to 25 per cent, VAT revenues could grow byHUF 400 to 500 billion. Half of the PIT andcontribution deficit could be covered from thesurplus VAT! It is commonplace today what agreat mistake it was to decrease the upper VATrate in 2006. VAT is the most easily collectibletax type, and being consumption related, it isalso one of the fairest. Unrealised contributionrevenues would be replaced by those who con-sume the most. This situation must be main-tained as long as the surplus revenues from therapid growth of the economy, freed from thehamstrung situation, restore the balance.

Corporate income tax

The corporate income tax rate is currently 16per cent, however together with the solidarity

Table 15

DUES PAYABLE ON THE AVERAGE MONTHLY WAGE

Fully taxed Fully taxed Difference per Difference forwages at the wages at the employee all employeecurrent rates new rates (HUF) (HUF billion/year)

Average monthly gross wage per person (HUF) 206,307 206,307 0 0 Dues payable by the employee 35,072 20,631 14,441 129,731 Tax credit 0 0 0 0 Actual PIT 48,771 30,946 17,824 160,121 Actual PIT rate 23.6% 15.0% 0 1 Net wage 122,464 154,730 –32,266 –289,852 Contributions payable by the employer 71,063 55,703 15,360 137,982 Total costs of employment 277,370 262,010 15,360 137,982


702

tax of 4 per cent 20 per cent of the profitaccording to the balance is paid as tax. In 2007,the state yielded HUF 510 billion from thecorporate income tax, and HUF 178 billionfrom the solidarity tax, i.e. altogether less than700 billion. The 15 per cent rate hardly makesany difference compared to the current rate.The statements compiled by Éva Palócz showthat the rate of actually paid taxes was only10.7 per cent in 2006, which can partly beattributed to the overly extensive system ofitems that influence the size of the pre-taxprofit, and partly to the large volume of dis-counts given by the Hungarian government tocompanies running major investment projects.(See Table 16)

Tax benefits are given to entities with out-standing tax payment abilities, i.e. the multina-tional companies. They run major investmentprojects, and they can make use of the norma-tive benefit provided for by the Act on corpo-rate tax. This year, for example, taxpayersimplementing investment projects worth overHUF 3 billion can use the so called develop-ment tax benefit. The benefit equals 40 per centof the project value in the case of projectsworth up to EUR 50 million. In the case ofinvestment projects worth EUR 50 to 100 mil-lion, the tax benefit is 20 per cent of the partabove EUR 50 million. If the total value of theproject exceeds EUR 100 million, a tax benefit

of 13.6 per cent can be claimed for the partabove EUR 100 million when paying the cor-porate income tax.

The tax benefits and large-scale subsidies aregiven to those who do not need them at all!This situation is disapproved by many.

For example, when analysing the low level ofcorporate income tax paid in 2006, TamásMellár pointed out: “If all enterprises had metthe normative tax payment obligation, the statebudget could have realised a surplus of HUF370 billion. However, this was circumvented bythe various tax benefits. And we still cannot saythat the benefits encouraged the enterprises,since in 2007 their economic growth signifi-cantly fell short of the growth rate of the coun-tries that joined the European Union togetherwith Hungary. The situation could not beimproved by industrial production either,which earlier grew at a dynamic pace. By theway, industry: according to balance sheet fig-ures, the effective tax rate in the industry was5.5%. Industrial companies paid a profit tax ofHUF 91.5 billion, while the tax benefits theyrealised totalled HUF 102.9 billion.”(TamásMellár, 2008)

On top of that, allegedly to encourageinvestments, the Hungarian government pro-vides these companies with subsidies grantedon the basis of case-by-case government deci-sions. Since 2003 “investment projects worth

Table 16

CORPORATE TAXES AND TAX BENEFITS

2005 2006(1) Pre-tax profit 3,375.7 3,471.6

(2) Profit increasing items (32 types) 3,276.2 4,337.9

(3) Profit decreasing items (44 types) 4,708.6 5,957.3

(4)=(1)+(2)-(3) The base of the calculated tax 1,860.3 1,896.9

(5) Calculated tax 488.4 485.1

(6) Tax benefits (15 types) 120.8 112.1(7) Payable tax 367.5 372.9

Source: Éva Palócz: The possible directions of the tax reform, KOPINT-Tárki Zrt., 2008


703

HUF 700 billion have been implementedthrough case-by-case government decisionsand state subsidies of HUF 200–300 billion.”(Ibolya Vitéz F., 2007) The article also revealsthat this type of investment encouragement isalso the hotbed of corruption.

We can see that the corporate income tax hasplenty of hidden reserves. By using thesereserves, the introduction of the 15 per cent taxrate would not decrease, but instead increaserevenues from this tax type, and would offsetlosses from the abolishment of the solidaritytax. Since these companies do not pay dividendtax either (see Table 17), due to the enormousvolume of untaxed dividends it would not beunfair to introduce a certain repatriation tax.However, I am careful about demanding such atax, since its introduction may violate interna-tional treaties.

Simplified entrepreneurial tax

As we could see, the abolishment of the simpli-fied entrepreneurial tax is a major stage in thefight against fictitious invoicing. With the sim-plified entrepreneurial tax no longer in place,revenues of HUF 150 billion should be madeup for. I must note that revenues from the sim-plified entrepreneurial tax grew fast in thebeginning, but remained under the expectedlevel in the last two years.

In the new tax system these companieswould pay corporate income tax and dividendtax on the profits that remain after thededuction of costs. The tax wedge of capitalincome would decrease in the new system:from 40 per cent to 37.5 per cent. In 2007,the gross revenue of companies paying sim-plified entrepreneurial tax was around HUF600 billion. If the simplified entrepreneurialtax of HUF 150 billion, which was collectedlast year, should be paid from the corporateincome tax and dividend tax base, said com-

panies would need HUF 400 billion in prof-its, which can be comfortably realised fromthe GDP they produce. It is highly probablethat the revenue loss from the abolishmentof the simplified entrepreneurial tax wouldbe replaced by the same taxpayers throughcorporate income tax and dividend tax pay-ments.

Growing tax revenues from smallentrepreneurs

I have pointed out several times earlier howfast the tax payment potential of theHungarian enterprises could grow after theyare freed from their bonds. The most criticalsegment of this sector comprises the smallestenterprises, i.e. (the nearly 700,000) privateentrepreneurs, the almost 200,000 limitedpartnerships, as well as people performinghousehold chores. It is well known that theratio of untaxed income, and the share of non-invoiced transactions is relatively the highestin this segment. According to the HCSO,these enterprises produced a GDP of 3,825billion in 2005 (to which we could add at leastHUF 500 billion as non-observed GDP). Ifwe deduct the employment costs of theemployees from this amount (HUF 534 bil-lion), we obtain the official GDP that thestate and the entrepreneurs must share. Thatreserves do exist here – not only in the formof virtual, but actual tax deficit – is best shownby the fact that in their own rights theseentrepreneurs paid only HUF 63 billion associal security contribution in 2005! It is notknown how much PIT and flat tax these enti-ties paid, but we are not mistaken if we state:the reduced rates must be paid by all entitiesin this sector. At least HUF 500 billion mustbe collected as surplus tax in order to offsetthe deficit that appears in the sectors of “lawabiding” taxpayers.


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Curtailment of subsidies

More and more people share the opinionaccording to which the Hungarian system ofsocial subsidies cannot be sustained anylonger. András Simor, the president of theNational Bank of Hungary called for anexpenditure reduction of HU 2,000 to 2,500in his article titled Revival! in the March 24,2008 issue of the Hungarian dailyNépszabadság. “The only problem is that ourcountry runs a welfare system that the econo-my is unable to maintain. This is in partresponsible for slow growth and the shortfallbehind the neighbouring countries. In otherwords, if we do not implement changes, if wedo not accelerate our growth, the high sumsrelative to the GDP that are currently spenton welfare expenditures will sooner or later beless – in absolute terms – than the lower per-centage that the neighbouring countries spendon welfare today. And believe me that ourneighbours spend less on such purposes notbecause there are less people in need in theircountries, or because they are more immuneto the problems of the poor, but because theyhave understood that their economies cannotafford larger welfare spending. Naturally,HUF 2,000 to 2,500 billion cannot be savedmerely by cutting welfare expenditures.Expenditures must be significantly curtailedin other budgetary chapters, too, since theburdens of high state debts require us to havemore frugal financial management than ourneighbours in all areas.”

In contrast with the rational streamlining ofsocial expenditures I see more chance in theelimination of corporate subsidies. I havealready modelled the gist of the problem inrelation to the taxes paid by the multinationalcompanies. Corporate subsidies distort thecompetition, and the required margin must becollected in the form of taxes. Corruption inthe distribution of subsidies cannot be eradi-

cated. It is always the case when those in chargeof distribution decide about giving away some-body else's money.

Here we can agree with István Csillag, whowrites the following in his above cited articleissued in the daily Népszabadság: “Programmesdesigned to assist job seekers, train peoplewhose jobs are threatened, or provide wage sup-port treat the taxpayers' money as handsomelyas in other cases of subsidies and supports.Nobody follows whether a former boiler-makerthat was successfully retrained to be a hatmaker(I know it is a bit of an exaggeration) could finda job, and for how many years he was employed.Therefore these training centres and pro-grammes “drain” the taxpayers' “gang money”for years and flood the labour market withhardly employable workforce. Retraining pro-grammes consume nearly 1 to 1.5 per cent ofthe GDP (HUF 250–300 billion from the tax-payers' money each year). The utilisation of thisenormous sum (3 to 4 per cent of the annualbudget) is not accompanied by efficiency tests,on the basis of which it could be determinedwhether it is only school owners and the dis-tributors of subsidies among the entrepreneurswho make a good deal, or employers in need ofqualified workforce and job seekers also benefitfrom the programmes?” (István Csillag, 2008)

The financial management organisations ofthe agricultural sector also receive dispropor-tionately large subsidies. We must not forgeteither that subsidies granted under the NewHungary Development Plan are co-financed bythe Hungarian taxpayers, too: Hungary's pay-ments to the EU reach almost HUF 200 billiona year. The entire plan should be reconsidered,at least in the sense that entities in the compet-itive sector should be granted subsidies exclu-sively if their tax revenue surplus can be quan-tified normatively, and the payment of suchtaxes can be guaranteed.

At least HUF 500 billion could be saved byradically curtailing subsidies given to the com-


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petitive sector. This much less taxes will needto be collected. We must not forget that deduc-tions by the state will remain high even withthe reduced tax rates of the new tax system. Itis vital to save on the expenditure side, too. Themost efficient tool for this is to stop payingsubsidies to entrepreneurs. The enterprise-friendly economic policy should not be basedon the distribution of subsidies, but rather onensuring a stable and predictable environmentthat encourages development. Low and afford-able taxes represent the best and most efficiententerprise-supporting system! On top of that,this pertains equally to everyone, and is sectorneutral in the most equitable manner.

Wealth tax

The tax revenues of the economic boom thatwill occur under the liberating effect of the newtax system and the rationally streamlinedexpenditure side of the budget can be balanced,already in the very short run. However, new taxtypes, such as the wealth tax, should also beintroduced. This tax would have a dual func-tion. On one hand, it could provide reserves forthe management of the difficulties in switchingto the new tax system. It could also provide alonger term remedy for the serious structuralproblems of the budget. The wealth tax shouldremain in place as long as the balance of thepension fund is restored. Last year the budgetcontributed HUF 841 billion to the socialsecurity funds!

Another painful problem of the Hungarianbudget is the high debt service burden. In 2007as much as HUF 1,110 billion was spent on thisservice. It is said by many, but perhaps mostloudly by László Gazdag that the most impor-tant economic policy objective is to curb infla-tion, since a mere one per cent growth in theinterest on Hungary's state debt of HUF16,000 billion leads to an additional budget

expenditure of up to HUF 100 billion. (LászlóGazdag, 2007.) It would be reasonable to usepart of the revenues from the wealth tax for thereduction of debts. The institution of thewealth tax should be maintained as long as thedebts reach a reasonable level.

On the other hand, the wealth tax would alsohelp restore the sense of social justice and atthe same time it could implement the principlesof family-friendly taxation that are difficult toenforce in personal income taxation. I wouldnot recommend a rate for the wealth tax, but itis worth examining the Swedish example. InSweden the wealth tax was abolished in 2007after it fulfilled its mission. Swedish citizenswith assets worth over EUR 200,000 had to paya wealth tax of 1.5 per cent a year. People withassets worth HUF 50 million had to pay HUF750,000 in wealth tax. The tax-base was calcu-lated not only on the basis of real property, butalso on the basis of the other types of assetsand bank deposits. The introduction of thewealth tax cannot be rejected based on theargument that it is complicated. We must studythe practice of countries that successfully applythis tax type. Taxing assets obtained fromuntaxed funds is an indispensable preconditionfor reducing or moral deficit!

* * *

In this study we have proved that there exists atax system in which the tax burdens on livelabour can be radically decreased while main-taining the balance of the – rationally reformed– budget. The new tax system will release thecreative energies of entrepreneurs and employ-ees who are now compelled to commit fraud ona day-to-day basis, and will serve as an enginefor rapid economic growth. The players of theeconomy will realise that they can meet bothends meet even without corruption. It is ashame that in today's Hungary there are hun-dreds of thousands of necessity tricksters and


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the leaders of the country do not seem toapprehend it!

No political party that is concerned aboutthe future of the country can have a moreimportant objective than that. If a wise andcredible politician explains the people thattaxes would be reduced to an affordable level,but in return it is expected that everybodywould pay them, the citizens will understandand appreciate it. Credibility is extremelyimportant: the new leadership must do its bestto perceivably reduce corruption in public

administration. It must meticulously watch thepurity of the members of the government andof the members of Parliament. The legal regu-lations that make tax evasion one of the mostdespicable crimes in the eye of the general pub-lic can and must be adopted only in this moral-ly restored environment.

The precondition for a new and competitiveHungary is the introduction of transparentand affordable taxes on one hand, and univer-sal, draconian sanctions on tax evasion on theother!

BOKROS, L. (2008): A közteherviselés félreformja(The half-reform of common charges), Élet ésIrodalom, 26 February

CSILLAG, I. (2008): “Van egy álmom... a 2/3-osMagyarország” (I've got a dream … the 2/3 Hungary)Népszabadság, 5 January

FEKETE, GY. ATTILA (2003): Hét év a pécsi szám-lagyárosra, Népszabadság, (Seven years of imprison-ment for the invoice factory operator in Pécs), 26November

FEKETE, GY. A. (2007): Számlagyár és pénzmosoda,Hárommilliárdot vettek fel fiktív elszámolásokkal(Invoice factory and money laundry, Three billionforints was pocketed using fictitious invoices),Népszabadság, 23 November

FEKETE, I. – LIGETI, CS. – PATAKY, P. (2008): A gazdaság kifehéredését vizsgáló bizottság jelen-tése (Report of the committee in charge of examin-ing the whitening of the economy), February,www.mkt.hu

GAZDAG, L. (2007): A Bokros-csomag mítosza és avalóság (The myth of the Bokros package and reality),Lexecon Kiadó Hatalmas adóteher alatt nyög a magyar(Hungarians are shouldering an enormous tax bur-den), (2008) Portfolio.hu, 12 March

KREKÓ, J. – P. KISS, G. (2007): Adóelkerülés és amagyar adórendszer (Tax evasion and theHungarian tax system), National Bank of HungaryNBH studies 65

KREKÓ, J. – P. KISS, G. (2007): Adóelkerülés és amagyar adórendszer (Tax evasion and the Hungariantax system), Institute of Economics, HungarianAcademy of Sciences, Seminars, 8 November

LIGETI, CS. (2007): A feketegazdaság, mint anemzetgazdaság teljesítményének része (The blackeconomy as a contributor to the performance of thenational economy), Hungarian Economic Association(MKT) Corvinus: Budapest Days of Economics

MELLÁR, T. (2008): Adócsökkentés, de kinek? (Taxreduction, but for whom?) Magyar Nemzet, 29 March

MIHÁLYI, P. (2008): Támogatás a támogatásért?(Support for support?) Élet és Irodalom, 28 March

OHNSORGE-SZABÓ, L. – ROMHÁNYI, B. (2007):How did we get here: Hungarian budget 2000–2006,Public Finance Quarterly, Issue 2

PALÓCZ, É. (2008): Az adóreform lehetséges irányai(The possible directions of the tax reform), KOPINT-Tárki Zrt.

PAPP J. (2006) : Bértúlterhelés (Overburdening ofthe wages), Népszabadság, 5 December

PAPP, J. (2007): A kényszercsalók országa (Thecountry of necessity tricksters), Népszabadság, 5March

PITTI, Z. (2008): Az innovatív vállalkozások szerepea gazdaság-politikai célok megvalósításában (The roleof innovative enterprises in the implementation of the

LITERATURE


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economic policy objectives), Interim report onresearch carried out in 2007 and 2008 by the PrimeMinister's Office and the Hungarian Academy ofSciences, Hungarian Academy of Sciences, 26 February

PITTI, Z. (2007): A társas vállalkozások gazdaságiteljesítményeinek tulajdonosfüggõ jellemzõi (Theowner-dependant features of the economic perform-ance of joint businesses), In: Nemzeti érdek, Year 1,issue 2

VADÁSZ, P. (2006): A király meztelen Avagy kiter-melhetõ-e a bérköltség (The emperor is naked or canwage costs be offset by production? Roving conferenceof economists, Nyíregyháza, 7 September

VITÉZ, F. I. (2007): Beruházók eltitkolt ked-vezményei (The secret discounts of investors), HVG,8 November

Employment Tax Evasion Schemes InternalRevenue Service, US Department of Treasury,www.irs.gov

Kovács a banktitok megszûnését reméli (Mr.Kovács is hoping for the elimination of the banksecrets (2008) NAPI Online, 4 April

Lemondott a Magyar Telekom vezérigazgatója (TheCEO of Magyar Telekom has resigned) (2006) Index5 December

Sereghajtók vagyunk az innovációban (Hungary isa tail-ender in innovation) (2007) Origo.hu 27February

Számlagyáros hajléktalanok a Siemens körül(Homeless invoice factory operators in the shadow ofSiemens) (2007) SG.hu 29 November


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T

Katalin Solt

The application of welfareeconomics to taxation

Theoretical approaches with different points ofdeparture often concentrate on the very same sub-ject, however, there are only few analyses in sci-entific literature that offer a comparison of studieswith different approaches. I try to apply this con-ception in my paper. Within that, I dwell on ques-tions that are “simple” to present with the theoret-ical approach of welfare economics, but theirpractical application raises doubts in many. I givea few examples to illustrate how theoretical mod-els can be transformed into models suitable forconcrete analyses. Then I sum up the most impor-tant elements of the views criticising the “tradi-tional” theory of the welfare effects of taxation,and provide a summary of those critiques bypointing out the contradictions of theoreticalmodels and practical applicability.

Problems of welfare crop up in different lay-ers in researches. One of the approaches exam-ines the measurement of social welfare, withinthat giving more and more prominence toresearches, and to indicators gained from them,that express a given society's level of develop-ment and wealth using indices or other finan-cial indicators which demonstrate more gener-al correlations of welfare than per capita outputor income (GDP or GNI) indicators. The cal-culation of indicators is now relatively wide-spread, but in the majority of cases there is nouniform methodology and, in particular, appro-

priate database. There is no need to prove whatdifficulties arise from the comparison ofincome per capita in different periods (justthink of the hectic price and exchange ratechanges and the related conversion bias). Datahandling presents problems even in the case ofindicators that are seemingly easy to deter-mine, such as measuring adult literacy, a com-ponent of the HDI (Human DevelopmentIndex). Statistics naturally offer some sort ofmethodological guidance, but actual literacymay be significantly different from statisticalfigures, and estimations may entirely distort itsresult. There is another example: when measur-ing the HDI, average life expectancy at birthwas calibrated between 25 and 85 years, howev-er, in 1994, average life expectancy at birth wasonly 24 years in Rwanda, a figure which couldnot be fitted in the index (Husz, 2001).

Another area of application is the analysis ofthe effects of various economic policy meas-ures, including the impact assessment of taxa-tion or transfers. In these cases, it is (would be)necessary to measure a welfare change. Welfarechange, however, cannot be measured directly,so researchers use proxy indicators. Resultsmay vary depending on the selected indicators.These kinds of researches and methods aretherefore sharply criticised by those who insiston the real presentation of welfare changes and


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also by those who reject, from the outset the,welfare economics' method and logic of analy-sis resting on neo-classical principles.

The third are associated with our topicincludes critical researches which intend towiden the concept of welfare, and make theefficiency and equilibrium criteria of tradition-al or mainstream economics the subject of crit-icism. Within this group, the evaluating andcritical works of advocates of ecological eco-nomics deserve special attention, works whichendeavour to extend the logical framework oftraditional economics, and thus give an entire-ly new interpretation to welfare.

Finally, I attempt to give an answer to thequestion as to why the concepts of welfare eco-nomics continue to prevail in the field ofapplied researches, why there has been no par-adigm shift so far as a result of criticism voicedby many and many times, and why changeshave been made to certain components only.

WELFARE ECONOMICS – BRIEF SUMMARY

The New1 Welfare Economics strives to evalu-ate economic situations from welfare point ofview, situations that cannot be handled underthe “classical” Pareto-principle. According toPareto-criteria, social welfare change can bejudged unambiguously if one economic player(or group)2 is made better off, while the other(others) are not made worse off. Any situationin which one economic player (group) is betteroff, and the other is made worse off cannot beevaluated from welfare point of view with thePareto-principle. The concept of the so-calledpotential Pareto-improvement is designed tooffer a solution for that. In the 1930s, Kaldor(1939) and Hicks (1939) outlined this solution.Since then, that has been considered as a pointof departure in the most diverse fields of eco-nomics (Cullis – Jones, 2003, Stiglitz, 2000).

According to the concept, comparison of twoPareto-optimal economic situations can bemade by the possibility of compensation orbribe. The method can best be illustrated withthe so-called utility-possibility curves. If situa-tion A enhances the welfare of one player inrelation to another situation (e.g. B), whichworsens the welfare of the other player, thensocial welfare will improve if the loser can becompensated from the gains, and the winnerwould still be made better off after the com-pensation. In other words, the winner is able tocompensate the loser. Its complementary sideis the bribe: if the loser is capable of ensuring tothe potential winner a welfare level the winnerwould have achieved in the new situation, andthe loser is still better off than would be in thenew situation, then the initial situation is betterthan the new one from the perspective of socialwelfare. An important element of comparisonis possibility, i.e. social welfare change does notdepend on whether compensation or bribe hasactually taken place, but whether there is a pos-sibility for it. This is called a Pareto-improve-ment.

Potential Pareto-improvement is generallyillustrated with simplified welfare situations inthe theoretical literature.3 It is worth observingthe representation, because it signifies a criticalcomponent in the application of the welfaretheory.

The presentation of compensation-bribepossibility is usually done by a consumption-possibility frontier curve. A utility-possibilitycurve shows utility distribution deriving fromthe possible distribution of a given set of goodsbetween two individuals. In two dimensions itmeans that a change in the utilities attainableby economic players can only be achieved atthe expense of one another. The function, intheory, does not require the measurability ofutilities, but assumes it implicitly. The individ-ual points of the utility-possibilities curvederive from the points of the so-called contract


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curve. The function does not contain theabsolute (cardinal) measurability of utilities,only assumes ordinal rankings. On the otherhand, in order to determine utility-possibilities,it is necessary to know the proportion ofchanges which is difficult to interpret fromordinal rankings, i.e. it can only be constructedusing actually measurable utilities.

The two extremes of the utility-possibilitiescurves represent the utility level which wouldbe attained by the given economic player if themaximum attainable utilities were at his dispos-al. The set of points connecting the twoextremes shows the utility combinations asso-ciated with the possible distribution of goods.The shape of the curve depends on the prefer-ence system of the two economic players. Thisfunction is concave in the case of “well-behav-ing” indifference curves.4 When the function isinterpreted more generally, they only indicatethat the utility-possibilities frontier is of adownward (negative) slope, because by dimin-ishing the utility of one economic player thatof the other increases. The uncertainty of afunction's shape is often depicted in the litera-

ture with a “sinuous” curve of an optionalshape. (Cullis – Jones, 2003, Becker and part-ners, 1999). For simplicity's sake, sometimeslinear shapes are used.

A utility-possibilities frontier curve can, firstof all, be used to demonstrate welfare changeswhich may theoretically come about as a resultof certain measures. If the possible trends ofwelfare changes with this method are“mapped” with this method, then the “only”thing to do is to assessg and evaluate thesechanges. Then what can this approach tell us intheory?

The comparison of the three points markedin Chart 1 represents the methodological start-ing point. First, every point that is on the utili-ty-possibilities frontier is definitely better thanthe ones below the curve. The latter are notefficient points, as they do not make use of allthe attainable utilities, i.e., the utility welfarelevel can by all means be increased by movingto the curve. This can be explained by standardmicroeconomic tools of analysis: two utilitycombinations are comparable by the Pareto-criterion, on the one part, and by the represen-

Chart 1

UTILITY-POSSIBILITIES FRONTIER (UPF-CURVE)

Utilitylevel of playerA

Utilityz level of player B

C

D

E


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tation of preferences, on the other. conse-quently, point C in Figure 1 will result in alower utility level than any points (for instance,points D and E) displayed on the utility-possi-bility frontier (UPF).

It is a different case when the points are onthe UPF curve. These points are not compara-ble with each other even under the Pareto-prin-ciple, as this means that one economic player ismade better off, while the other is made worseoff.

These correlations can only be used for eval-uating taxation if the utility interpretation iswidened, i.e. if purchasable goods are examinedinstead of the consumption of a given set ofgoods, in other words, attainable utilitydepends on the consumer's disposable realincome. (The amount a consumer can purchasefrom a given set of goods.)

This method is used for evaluating hypothet-ical tax changes. Let us assume that a govern-ment changes the level of income tax rate andreduces its progressivity. For simplicity's sake,linear income tax is introduced instead of theformer progressive income tax. As a conse-

quence, the situation of individuals with differ-ent income will change differently: the realincome of some will grow, while that of theothers will decrease. Let us suppose that as aresult of that the UPF-curve changes as shownin Chart 2. The figure shows that the maximumutility level of economic player A will be high-er due to the change, while that of economicplayer B will be lower. The welfare changedepends on the actual initial utility distribu-tion, and on the type of distribution that willdevelop as a result of the change.

If the initial utility distribution is D, then nopoint can be found on H2 that would improvethe position of both economic players. Thus, inthat case, the change is unfavourable for every-one. On the other hand, if the initial situationis in E, then there is a utility distribution that ismore favourable for both economic playersunder the new conditions. According to theconcept of potential improvement, economicplayers do not necessarily have to experience ade facto improvement in their position, insteadwhat is really significant is that the winnershould to be capable of compensating the loser.

Chart 2

INTERPRETATION OF A POTENTIAL PARETO-IMPROVEMENT

Utility level of player A

Utility level of player B

D

H1

H2

E


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The above situation may however lead to con-tradictions. The points left from the intersec-tion of the two curves furnish proof thatreturning from the new situation to the originalwill be potentially better. That is to say, that thelosers would be capable of bribing the winnersby assuring them a utility level correspondingto the first situation. In order to eliminate thiscyclical problem, Scitovsky (1941) proposeddouble criteria for the potential Pareto-improvement. Based on that, it needs to bedemonstrated that the winners of the changecan compensate the losers, and thus they arguefor the change (Kaldor-criterion), and it needsto be demonstrated that the losers cannot bribethe winners (Hicks criterion).5

This type of evaluation of social welfarechange is explicitly related to the normativityof economics. Pareto originally thought thatout of two optimal situations the one that soci-ety judges superior should be chosen, i.e. heproposed ethical principles be applied in theevaluation. Under the concept of the new wel-fare economics, there is a need for tools andmethods which are free from any social valuejudgement and can only be evaluated on thebasis of stringent and rational efficiency princi-ples. In Kaldor's view, “There is no need for theeconomist to prove – as indeed he could neverprove – that as a result of the adoption of a cer-tain measure nobody in the community isgoing to suffer. In order to establish his case, itis quite sufficient to show that even if all thosewho suffer as a result are fully compensated fortheir loss, the rest of the community will stillbe better off then before “ (Kaldor, 1939).

Not even the original and expanded versionof the Pareto-principle is suitable for selectingthe best of the utility possibilities. Social utili-ty functions serve that purpose. There arediverse ways of interpreting the functions(Varian, 1995, Berde – Petró, 1995), based onwhich there are various methods to select theoptimal of the utility-possibilities.

In its most common interpretation socialwelfare is described with a standard tool ofmicroeconomics. Just like a household con-sumption function which is drawn as the quan-tity of various goods consumed and as thefunction of household utility, similarly, a soci-ety's welfare functions can be derived from theutility functions of its members. The so-calledsocial indifference curve can be constructedwith the social welfare function. Each point ofthe curve contains individual utility combina-tions which produce the same aggregate utility,i.e. the same social welfare. As a result, socialwelfare maximization opens to two interpreta-tions:

• With given resources, a utility distributionwill result in maximum social welfareunder which distribution the utility-possi-bility curve is tangential to the highestsocial indifference curve;

• The highest social welfare can be achievedby moving the utility-possibility curveoutward, i.e. increasing the production.

Chart 3 shows a utility-possibilities frontier(UPF) and social welfare indifference curves(W1 and W2) of a society consisting of twoindividuals. The maximum welfare of the soci-ety is indicated by point C under given condi-tions.

The social welfare function also representsan equity standard. It is easy to see that thegreater the aversion from inequality the steep-er the social indifference curve, i.e. thosebecoming “poorer” must sacrifice an increasingamount of utilities to assure that the welfare ofthose becoming “richer” is increased by a unitof utility.

IS SOCIAL WELFARE MEASURABLE?

As described above, it is indispensable for us tohave some sort of an indicator of social welfareand social utility for analysing the effects of


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taxation. A social welfare function cannot beconstructed in the form it is represented in thetheoretical literature. Welfare functions arebased on individual preferences which are how-ever not known. It would therefore be neces-sary to construct the social welfare function inanother form. In most cases, there are onlyindirect solutions which approximate socialwelfare using proxy indicators. The selection ofindicators depends on whether it can be accept-ed as a hypothesis that there is a correlationsimilar to a curve constructed under microeco-nomic principles.

Welfare approaches based on neo-classicalprinciples rely on the assumption that widen-ing consumption leads, at the same time, togreater social welfare. According to the aboveapproaches, social output (GDP per capita andconsumption per capita within it) is thus theindicator suitable for the measurement of wel-fare. Simulation models used for analysing theimpact of economic policy measures on house-holds also rest on the same principle. The crit-ical views according to which output and con-sumption are not suitable for the measurement

of social welfare are more and more widelyaccepted.

Certain concepts even question whethersocial welfare is a rational idea at all, namely,whether the social welfare function is theoreti-cally acceptable. Within this group, theAustrian school represents the most consistentand critical standpoint. Its axiom is that neitherindividual utility functions nor indifferencecurves exist. Judging utility is possible in oneway only: on the basis of human actions. Allpreferences must be revealed in actions. Butthese actions are individual and discreet, so theexistence of continuous individual utility func-tions is not possible (Mises, 1966). Since indif-ference cannot be demonstrated in action,therefore indifference cannot be demonstratedat all. “If a man were really indifferent betweentwo alternatives, he could not make any choicebetween them, and therefore the choice couldnot be revealed in action” (Rothbard, 1962). Ifthere are no individual utility and indifferencefunctions, there can be no social indifference orwelfare function either. On the other hand, thesocial welfare function implies that society

3. ábra

MAXIMUM WELFARE OF THE SOCIETY

Utility level of player A

Utility level of player B

C

HLH

W1

W2


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makes the choice, individuals make collectivechoice from different combinations. And thatis an absurdity in the opinion of the Austrianeconomists.

The majority of critics are naturally muchmore “understanding”. The most well-knownamong them is Amartya Sen's whose conceptsare accepted by a large number of followers. InSen's view, on top of financial resources thereare other factors equally important in individ-ual preferences determining the quality of life.Welfare depends on the availability of possibil-ities by the acquisition of much-valued life con-ditions.

Researches made great headways in the1980s. They were aimed at developing measure-ment of the quality of life (a new concept ofsocial welfare). The UN, the OECD and theEU have provided considerable funds for theresearches, since these organisations consid-ered it more and more important, for variousreasons, to compare the welfare levels of mem-ber states more comprehensively than allowedby production and consumption indicators.Endeavours to improve the quality of lifebecame integrated into political programmes,too.

The indicators developed can be classifiedinto two groups. One group includesapproaches which focus on individual evalua-tions and try to apply various subjective meas-ures. The other is composed of views whichcomplement indicators designed to measureproduction output with the measurement ofsocial-level phenomena. That latter group con-tains the most well-known welfare indicator,the Human Development Index (HDI). TheHDI is based on the assumption that, apartfrom the quantity of consumption, people'squality of life is determined by long andhealthy life and educational opportunities. Theopportunities referred to are measured by lifeexpectancy at birth, adult literacy rate and aver-age time of education. Indices of human devel-

opment have been calculated on a regular basissince 1990 within the framework of the UNDP.

Measuring subjective welfare is still in anexperimental stage. Although such measure-ments are performed regularly in certain coun-tries (for instance, in the USA, Netherlandsand Germany), systematic and reliable data arenevertheless still fragmentary, which limitstheir use in decision-making. (Husz, 2001,Hegedûs, 2001, Lengyel, 2002)

Experts addressing the issue of environmen-tal problems have made considerable contribu-tions to the development of welfare indicators.Environment is typically a factor that deter-mines quality of life and occurs neither in mar-ket relations nor in social living conditions.

The Index of Sustainable Economic Welfare(ISEW) was developed in 1989 by HermanDaly and John Cobb. Their purpose was todemonstrate that there is no correlationbetween the change of GDP and genuine wel-fare: GDP growth and economic growth arenot accompanied by a welfare level increase ofindividuals in the society. Its advantage, com-pared to GDP, is that the index not only con-siders a given year's consumption, but reflectsa long-term approach. It takes into accountincome distribution, household and commu-nal services and long-term environmentaldamages.

The calculation of the Genuine ProgressIndicator, i.e. GPI, – similarly to the ISEW – isbased on the country's personal consumptioncorrected with the factor of income distribu-tion, and then modified with factors expressingfurther social and ecological costs and benefits.The indicator was coined by Clifford Cobb andhis partners in 1995 (Marjainé, 2005, Kerekes,1998, Kis – Pál, 2006).

Welfare indicator estimations are also madein Hungary, however, they are only fragmental-ly taken into account in economic policy deci-sions. (Lengyel, 2002, Marjainé, 2005) Muchmore detailed and accurate calculations are


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available for aspects that are more directlyrelated to economic policy decisions, includingtaxation decisions.

MEASURING THE WELFARE EFFECTS OF TAXATION

Following the principles of welfare economics,the welfare effects of an economic policy meas-ure could be demonstrated if it could be toldhow the utility level, or more widely the wel-fare, of economic stakeholders will change.Strictly speaking, individuals' utility functionsand their preferences associated with differentincome and price levels should be known, andin the knowledge of the above factors, even apotential Pareto-improvement could be estab-lished.

A fundamental problem of welfare econom-ics is that the axioms of consumer decisionsrelate to only one individual or representativeeconomic player, but the theory fails if thereare more persons concerned. If there are two ormore individuals, it cannot be proved – underthe narrow interpretation of the neo-classicaltheory – that a decision is preferred by more asopposed to less.

To resolve the problem, indirect evaluationcan be applied. Indirect evaluation is partlybased upon the development of income, uponconsumption levels associated with differentincomes as well as questioning. Questioning isprimarily aimed at connecting individualincome levels with utility. The surveys endeav-our to show the evaluation of income units,and then reconstruct some social utility func-tion from them.

The so-called micro-simulation model is atypical method to deal with the above problem,and it models household decisions based onimpact assessments. Such models have also beenprepared in Hungary, and are used for impactassessment of economic policy and taxation

decisions (Benedek – Lelkes, 2005, Benedek –Firle – Scharle, 2006).

What theoretical and methodological criti-cism can be raised against these methods?

One of the problems is that these solutionslook upon, first of all, income (including con-sumption or saving) as an almost exclusive meas-ure of welfare. The models are based upon thepurchasing and saving habits of a given time (oran earlier period). They are thus not able to takeinto account changes induced by taxationchanges. These limitations are clear both to thosewho construct and use the models. They them-selves point out that the models are suitable forshowing the directions of changes only, but notfor forecasting accurately the actual effects.

The other essential issue is how the ques-tioning is conducted, and what models are cre-ated as a result of the inquiry. We can only givean indication of the problems in our paper,because each survey represents them in differ-ent forms.

When designing questionnaires, questionconstruction already assumes a certain direc-tion of replies. If the responder gives (or gave)a different answer than expected, it is disre-garded or left in the group of hypothetical eval-uations. For instance, responders are requestedto give market or monetary value to eachobject, although it may not correspond to theirscale of values.

Consumer behaviour is generally simulatedon principles formulated by neo-classicalmicroeconomics. As a result, simulation mod-els are not able to handle consumer behavioursthat diverge from the neo-classical axioms andare already supported by evidence. To illustratethe above, please refer to the summary offeredby John Gowdy on the possible differences.(See Table 1)

Experience shows that individual preferencesare often irregular. Lexicographic preferencemeans that a consumer is not willing to acceptsubstitution, i.e. gives absolute preference to


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one product or, in a general, one necessity toanother. The consumer is not willing to give upa given necessity no matter how much it costs.(This behaviour is also typical in case of addic-tive goods, where even high prices are notenough to divert one from consumption.)

According to the traditional micro-econom-ical assumption, individuals place a higher valueon present utility than on a future one. (Thereis less value set now on future expected utilitythe degree of which is the same as today. So thepresent value of future expected welfare is lessthan its future value.) If however a consumer'stime preference is “inconsistent”, then he setsthe same (or perhaps higher) value on futureutility than on a present one. This behaviour isapparent, for example, in one's inheritancetrends and in sacrifices made for preservationof the environment.

The results of experimental economics showthat a good proportion of people hold on toobjects they have obtained, and generally placea higher value on objects they own than objectsthey do not. (The phenomenon is referred to asendowment effect.) In other words, people donot always have to pay for what they look uponas better. The difference between giving prefer-ence (acceptance) and the willingness-to-payposes a methodological difficulty in the evalua-tion of public goods and services or environ-mental elements.

Preferences, the judgement of utility, oftendepend on the process of decision making andon how one's needs are met. Wrong conclu-sions can be made if no notice is taken of that,and consumer decisions are modelled only inview of results.

We have long been aware of how consumerbehaviours influence each other. These phe-nomena are partly known (demonstrationeffect, snob effect, etc.), nevertheless, theirconsequences cannot or can only be assessedsubsequently.6

The use of modelling solutions and proxyindicators may, at times, lead to conclusionsinconsistent with the initial assumption.Indicators and indices suitable for measuringhorizontal equality are widely used for measur-ing taxation effects. These are normally createdby giving different weights to various incomegroups, and thus balance (presumed) welfaregaps. On the other hand, if the mentionedweights do not correspond to actual utility dif-ferences, then taxation calculated on horizontalequality indicators may worsen actual socialwelfare contrary to its specific objective ofachieving a potential Pareto-improvement(Kaplow, 2000).

The other area within the welfare effects oftaxation to be analysed is the application of theso-called utility rule. The utility principle oftaxation sets out that taxation should be in

Table 1

DIVERGING NEO-CLASSICAL AXIOMS AND EXPERIENCE IN CONSUMER BEHAVIOUR

Expressed preferences Consumer decision axiom Behaviour assumptionsLexicographic preferences Continuous utility function Everything is marketable

Hyperbolic discounting Time preference behaviour Straight-line discounting

Endowment effect Symmetric rationality Willingness to pay = willingness to accept

Interaction of individual preferences Independent consumer decisions No collective decision/public choice,

no altruism

Process-dependent preference Outcome-dependent preference Process is irrelevant, only the final

outcome matters

Source: Gowdy, 2004, page 246


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conformity with the utility of public servicesfinanced from taxes. In order to assess preva-lence of the principle, it would be necessary toknow the utility of public goods and services.The assessment of public goods and services isoften made by cost-benefit analysis. Themethod's criticism is discussed in the sectionon environmental problems, where similar inci-dents are involved.

NATURAL ENVIRONMENT AND TAXATION

The mainstream school of environmental eco-nomics follows neo-classical principles. Itswidespread toolbox (taxation, market for pol-lutants, determination of emission, etc.)means, in theory, the application of welfareeconomics principles to negative externalities.The appropriateness of the tools and principlesis strongly attacked by proponents of ecologi-cal economics. The basis of the criticism is thatrules formulated up and applicable for marketeconomy cannot and must not be applied forthe natural environment. The coexistence ofnatural environment and human society canhowever hardly be looked upon as a marketproblem. As a result, it is not possible toanalyse environmental damage rehabilitation,preservation of the natural environment andthe safeguarding of sustainable developmentwith the tools of traditional economics.

The main strain of criticism can be sum-marised as below. Based on the assumption thatthere is a correct and optimal price, and thusthere is an optimal balance, for every environ-mental service, the economic theory proposesthat polluters are to pay all the marginal costsof the damage caused by them. This providesan incentive for diminishing the damage to asocially optimal level. The practical means ofthat approach include Pigovian taxes, nego-tiable permits and reimbursement of stocks.The disadvantages of such economic tools have

been identified: negative income redistributioneffect, smaller environmental effect than withdirect regulation, and it is difficult to establishthe amount of the necessary tax that assuresthe theoretical optimum.

The main principle of the traditionalapproach strives after accomplishing social effi-ciency, which is expected from market-basedincentives in the environmental policy.Evolutional features are ignored in policydevelopment, i.e. quality changes that are irre-versible and unpredictable and do not movealong equilibrium situations. The starting pointof efficiency is in any case short-lived andweak. An environmental policy based on cost-benefit calculations measured in monetaryterms entails the risk that it stimulates/sup-ports sustainable economic-social componentsand sacrifices long-term stability for the sake ofshort-term optimum and efficiency. This alsoapplies to climate policy, in which economicresearches are centred on optimalization (vanden Bergh, 2004).

CONCLUSIONS

Since the birth of the science, economists havepaid utmost attention to the role of the state,including within that governmental finances.One of the main goals of economics is to showwhy there is or there is no need to influence thefunctioning of the economy with governmentalinstruments. No matter what economic philos-ophy a government follows, what proportionnational revenue centralization reaches, whatrole a government assumes in the provision ofvarious public goods and services, there is aneed for tax revenues to fulfil the functions.Taxation is therefore indispensable in any eco-nomic analysis on the role of the state. Theproblem can be approached from differentaspects even in the theory: macroeconomics,microeconomics, community-based econom-


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ics, welfare economics, public finance and thetheory of public choice alike treat taxation as apriority but from different points of view.Almost every theoretical and applied economicarea tries to establish “optimal” or “efficient”taxation principles for the evaluation of a taxtype, tax rate or a tax system.

Theoretical approaches with different pointsof departure often concentrate on the verysame subject, however, there are only fewanalyses in the literature that offer a compari-son of studies with different approaches. I havetried to apply this conception in my paper.Within that, I have dwelt on questions that are“simple” to present with the theoreticalapproach of welfare economics, however, theirpractical application raises doubts in many. I have given a few examples to illustrate howtheoretical models can be transformed intomodels suitable for actual analyses. Then I havesummed up the most important elements ofthe views criticising the “traditional” theory ofthe welfare effects of taxation, and provided asummary of those critiques by pointing out thecontradictions of theoretical models and prac-tical applicability.

The welfare effects of taxation are given spe-cial attention in each country's economicimpact assessment. The methods of analysisrest, in most cases, upon the principles of tra-ditional welfare economics with the intentionto represent them in one way or another. Onthe other hand, the economic literature hasalready made several critical remarks on welfareeconomics based on neo-classical principles,and pointed out that erroneous conclusionsand wrong solutions may be made by basinganalyses exclusively upon these principles. Theanalyses rely upon past behaviour, and assumeeconomic players behave in a way which, to alarge extent is, no longer relevant. Calculationsmay therefore produce distorted results.

The critical comments that the expectedimpacts can only bring short-lived results andmay abandon long-term national economicgoals are also worthy of consideration. If gov-ernments pursue only short-term goals in taxcompetition (Losoncz, 2006) and disregard thewelfare impact of direct investment inflows,then they may sacrifice the short-term welfareof the national economy for the sake of long-term objectives.

How can it be explained that economicadvisors and those who prepare decision mak-ing ignore or hardly consider the criticalremarks put forward for several decades? I believe it has two main reasons: first, theacademic thinking and the general economicview insist strongly on panels applied by wel-fare economics. According to neo-classicalprinciples, closed systems can be built andmodels which are fully adjustable to the con-cept of the economy. Critics' proposals“knock down” those systems. There are fewsolutions which have brought about such auniform system. Many hold the view that thereplacement of certain elements would giverise to inconsistency. The other reason whythe critical comments are passed over is thatan economic database is still to be set up withthe help of which alternative approachescould be quantified at national economiclevel. It would be necessary to apply the qual-itative method of cost-benefit or to conduct aregular inquiry involving a large number ofrespondents for the broader interpretation ofwelfare, efforts that are not or only partlyfinanced by governments.

The situation gives cause for alarm, sincepoliticians keep asserting principles that areaccepted by the majority of economists ascommonplace. For this reason researches mustmore often emphasise the importance of alter-native approaches.


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1 The word “new” indicates that the Pigovian welfareeconomics resting upon traditional (measurable)utility is replaced by the Paretian interpretation ofthe general equilibrium theory which is based on theordinal utility concept. The critical remarks willreveal that the ordinal interpretation “steals back”the measurability of utility into the theory, and thusthe difference between old and new is of a method-ological nature.

2 The original welfare theory is concerned exclusivelywith individuals. A frequent topic of welfare debatesis the interpretation of welfare to groups or to socie-ty as a whole. The debate is centred on whether utili-ty can be added up, and if so, how it can be added up.We will come back to this problem when talkingabout the debates around the social welfare function.For the time being, we assume that a group's welfarecan be determined.

3 The representation makes it easier to understand theessence of the analysis, however, such a situationanalysis cannot be conducted in reality.

4 For the fundamentals of microeconomical analysissee Varian (1995) Chapter 30

5 De Gorman (1955) proved that the Scitovskian solu-tion undermines the assumption of transitivity.

6 The irrational indebtedness of a part of Hungarianhouseholds is probably the result of such mutualinfluences. The tempting consumption opportuni-ties and the consumption habits of these with higherincome “encourage” lower-income households totake up credit.

BECKER, A. – BECKMANN, K. – LACKNER, E. (1999):Grundzüge der Finanzwissenschaft, Universität, Passau

BENEDEK . – FIRLE, R. – SCHARLE, Á. (2006): Ajóléti újraelosztás mértéke és hatékonysága (The sizeand efficiency of welfare redistribution), Ministry ofFinance Research Papers (PM Kutatási Füzetek)

BENEDEK, D. – LELKES, O. (2005): A mag-yarországi jövedelem újraelosztás vizsgálatamikroszimulációs modellel (An examination ofincome redistribution in Hungary, using a micro-simulation model), Ministry of Finance ResearchPapers (PM Kutatási Füzetek)

BERDE, É. – PETRÓ, K. (1995): A különféle has-nosságfogalmak szerepe a közgazdaságtanban (Therole of different utility concepts in economics),Economic Review (Közgazdasági Szemle), Number 5,pp. 511–530

VAN DEN BERGH, J. C. J. M. (2004): Optimal climatepolicy is a utopia: from Quantitative to QualitativeCost-benefit Analysis, Ecological Economics, 48, pp385–393

CULLIS, J. – JONES, PH. (2003): Közpénzügyek ésközösségi döntések (Public finance and publicchoice), Aula, Budapest

GORMANN, W. M. (1955): The Intransitivity ofCertain Criteria Used in Welfare Economics. OxfordEconomic Papers 1, pp. 25–35

GOWDY, J. M. (2004): The Revolution in WelfareEconomics and Its Implications for EnvironmentalValuation and Policy, Land Economics, 2 pp. 239–257

HEGEDÛS, R. (2001): Szubjektív társadalmi indiká-torok – szelektív áttekintés a téma irodalmából(Subjective social indicators – selective overview of theliterature of the theme), Sociological Review(Szociológiai Szemle), Number 2, pp. 58–72

HICKS, J. R. (1939): The Foundations of WelfareEconomics, Economic Journal, December, pp.696–712

HUSZ, I. (2001): Az emberi fejlõdés indexe (HumanDevelopment Index – HDI), Sociological Review(Szociológiai Szemle), Number 2, pp 72–83

KALDOR, M. (1939): Welfare Proposition onEconomics and Interpersonal Comparisons of Utility,Economic Journal, September, pp. 549–552

KAPLOW, L. (2000): Horizontal Equity: NewMeasures, Unclear Principles, NBER Working Paper 7649

NOTES

LITERATURE


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KEREKES, S. (1998): A környezetgazdaságtan alapjai(The fundamentals of economics), BudapestUniversity of Economics and State Administration(BKÁE) Department of Environmental Economics andTechnology, Budapest

KISS, G. – PÁL, G. (2006): Környezetgazdaságtan(Environmental economics), Universitas Gyõr Kht.

LENGYEL, GY. (ed.) (2002): Indikátorok éselemzések (Indicators and analyses), Mûhelytanulmá-nyok a társadalmi jelzõszámok témakörébõl (Workingpapers on social indicators), BKÁE, http://web.uni-corvinus.hu/szoc/doc/lengyel/ lengyel_indikatorok.pdf

LOSONCZ, M. (2006): EU tax harmonisation and taxcompetition – lessons to Hungary, Public FinanceQuarterly (Pénzügyi Szemle), Number 3, pp. 474-489

MARJAINÉ SZERÉNYI, ZS. (2005): A feltételesértékelés alkalmazhatósága Magyarországon (Theapplication of hypothetical evaluation in Hungary),Academic Publisher (Akadémiai Kiadó), Budapest

VON MISES, L. (1966): Human Action, 3rd revisededition, Contemporary Books, Chicago

RAMMEL, CHR. – VAN DEN BERGH, J. C.J.M. (2003):Evolutionary Policies for Sustainable Development:Adaptive Flexibility and Risk Minimising, EcologicalEconomics, 47, pp. 121–133

ROTHBARD, M. (1962): Man, Economy and State,Princeton, Van Nostrand, latest edition: 1993, Ludwigvon Mises Institute, Auburn

SCITOVSKY, T. (1941): Note on Welfare Propositionsin Economics, Review on Economic Studies,November, pp. 77–88

STIGLITZ, J. E. (2000): A kormányzati szektor gaz-daságtana (Economics of the public sector), KJK-Kerszöv Legal and Business Publishing Ltd., Budapest

VARIAN, H. R. (1995): Mikroökonómia közép-fokon (Intermediate micro-economics ), Economicand Legal Publishing House (Közgazdasági és JogiKönyvkiadó), Budapest


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T

László Klicsu

Sustainable society – flat tax

The title of this essay may be surprising at firstglance, so it might be a good idea to explain howsustainable society has been coupled with flattaxes. In Hungary – but also in other countries –few would associate flat taxes with support forfamilies, raising children, or marriage. Indeed,there could be a link between them. It is easy toacknowledge that human beings are the ones thatcarry, generates, and pass on all those complexitiesthat allow them to live as part of a community –the society. Families represent the stage where thistransfer is mostly and traditionally done. By con-sidering the role of families, marriage, and theraising of children, one can reach the realisationthat the sustainability of any society requires soli-darity among the generations of the past, present,and future. When translated into numbers, inmodern societies this solidarity is manifested pri-marily in tax laws and social security laws. Thequestion, therefore, should be rephrased to expresswhether tax laws could and should have a role inconcepts related to sustainable society. And if therole of tax laws should be sought, why could notwe take international examples and see whether aregime of flat tax could serve the sustainability ofthe society?

Accordingly, this essay will address demo-graphic first, then certain constitutional require-ments related to public burdens, including theinstitution of marriage and families as well as

understanding of the fundamental rights of chil-dren in connection with taxation will be dis-cussed, followed by a German draft bill of a flattax system that has received great publicity, itsimpacts on redistribution as well as argumentsagainst it, and finally a Hungarian study thatscrutinised the potential impacts of a Slovakian-type flat tax regime in Hungary.

DEMOGRAPHICS

According to UNESCO, the most prominentcriteria and universal requirements of a sustain-able society are social fairness, based on theconcepts of ensuring equal chances for all toaccess opportunities and of a mutual share inpublic burdens; constant endeavour to improveliving standards; sustainable usage of naturalresources, which requires environment-consciousactivity by the society; preservation of the qualityof the environment. According to the generallyaccepted view, implementation requires a sys-tem-based approach and governance whoseinstitutional and governmental manifestation isa system of institutions that integrates alldimensions of sustainable progress.1

Regarding social sustainability, a number ofproblem scopes can be defined as indicated byliterature. One of them is the issue of demo-


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graphics, families, and children.2 In the devel-opment of the composition of a population,particular attention should be given to expect-ed changes in Europe, a decline in populations,and an increasing extent of demographic age-ing. (See Table 1)

It is clear that lack of children is one of themain reasons for this process. A typical data,there were just 9.66 births for a population of1,000 in Hungary in 2007 and 8.20 births inGermany. With these results, Hungary takes200th spot and Germany takes 221st place in alist surveying 223 countries.3

Obviously, long-term actions or actions withlong-term impacts must serve the welfare ofsociety – constant welfare for present andfuture generations – in each scope.

Despite having limited impact, tax laws can-not be exempted, either. However, tax lawsmust meet the criteria of constitutional law.

CONSTITUTIONAL PRINCIPLES OF PUBLIC BURDENS

Let's see the constitutional background. Themost obvious legislation is Article 70/I. of theConstitution, describing the obligation to con-tribute to public revenues.4

The Constitutional Court has explainedArticle 70/I. of the Constitution in a numberof decisions. According to the findings of theCourt, the government has great liberty inchoosing what economic source as the startingpoint of tax payment and in selecting the scopeof taxable assets.5 In accordance with the reso-lutions of the Constitutional Court, Article70/I. of the Constitution does not prevent thegovernment from prescribing other paymentobligations (for instance, sales and propertytaxes, duties, customs duties, contributions,fines, fees, etc.). The extent and method ofcontribution to public revenues are describedby laws on taxes, duties, contributions, etc.6

Article 70/I. of the Constitution does not saythat tax payment obligations cannot be pre-scribed for enterprises that make losses interms of income7. Legislators have great free-dom in ways of developing the tax system: It iswithin the consideration of legislation and thegovernment's economic policy within the lim-its ensured by the Constitution, theConstitutional Court decided.8

When interpreting Article 70/I., it is essen-tial to understand that the word income andassets do not refer to taxable property, eventhough there have been seemingly contradicto-ry resolutions by the Constitutional Court.9

Table 1

POPULATION CHANGES IN DEMOGRAPHICS BETWEEN 2005 AND 2050

Basik scenario by Eurostat, EU-25 2005–2050 2005–2010 2010–2030 2030–2050Total population –2.1 +1.2 +1.1 –4.3

Children (0–14) –19.4 –3.2 –8.9 –8.6

Youths (15–24) –25.0 –4.3 –12.3 –10.6

Adults (25–39) –25.8 –4.1 –16.0 –8.0

Adults (40–54) –19.5 +4.2 –10.0 –14.1

Adults (55–64) +8.7 +9.6 +15.5 –14.1

Adults (65–79) +44.1 +3.4 +37.4 +1.5

Adults (80+) +180.5 +17.1 +57.1 +52.4

Source: EC (2004), Green Book, A demográfiai változások kihívása, a nemzedékek közötti szolidaritás új formái, [Demographic Challenge, NewForms of Solidarity Among Generations] COM (2005) 94 final, http://ec.europa.eu/regional_policy/conferences/demographicchallenge_jan07/doc/presentations/ageproofing_toolkit_hu.doc


723

All Article 70/I. says is everyone has “the obli-gation to contribute to public revenues on thebasis of their income and wealth”.

Conversely, the Révai Encyclopaedia10

defines taxable assets as “any such object oraction after which the taxpayer is obliged topay tax. The tax asset shall be the property inquestion in the case of property tax; the rent ofland, house, capital, etc. in the case of rent tax;the income in the case of wage tax; the taxablegoods in the case of consumption taxes; trans-fer actions, legal transactions and deeds thereofin the case of sales tax.”

Today – according to Gábor Földes11 – lawschools teach students that tax assets are phys-ical objects, rights, legal relationships, facts ortitles subjected to taxation. The taxable value isthe pecuniary value or quantity of the tax asset.Tax assets could be anything with pecuniaryvalue or quantity and is in some loose connec-tion with the taxable person and their incomeor wealth. The government has a large amountof freedom as to what economic source isselected as the core of tax payment and on thisbasis what is defined as tax asset.12 Pursuant tothe practice of the Constitutional Court,Article 70/I. of the Constitution does not dis-allow the government to prescribe other pay-ment obligations (for instance, sales and prop-erty taxes, duties, customs duties, contribu-tions, fines, fees, etc.).13

Conversely, the tax source – according to theRévai Encyclopaedia – is “the total of assetstaxes are paid from. Accordingly, taxes can bepaid from income or wealth. Some authors oflegal texts – such as Wagner – say taxes may bepaid from capital assets, because this way thedivision of wealth and income can be influ-enced favourably. This type of taxation tells ofa strongly democratic stream, but it cannot berecommended outside the scope of inheritancetaxes because the tax – regarded as a recurringservice – cannot fulfil its intended purpose incase the wealth is exhausted, and would

decrease savings. Therefore, income could bethe only reasonable tax source, and the extentof tax should be no more than what is left afterprimary necessaries.”

This last sentence is relevant as to interpret-ing Article 70/I., and it may be a good idea torecall how public burdens were regarded at thetime14: “Therefore, income could be the onlyreasonable tax source, and the extent of taxshould be no more than what is left after primarynecessaries.” Consequently, Article 70/I. shouldlead to the concept – if historical interpretationof public contributions were to be followed –that taxation must not put taxpayers in animpossible (financial) situation. Taxpayers haveto pay public contributions (under almost anytitle) in line with their income/wealth posi-tions. In another, more up-to-date, interpreta-tion, this means the (constitutional) require-ment of tax exemption for minimum subsis-tence.15

Also, it means another requirement that tax-ation cannot be of excessive extent or of a con-fiscatory nature. According to Resolution1558/B/1991. of the Constitutional Court,progressive, bracket-based taxation in the caseof personal income tax is considered constitu-tional until the extent of tax reaches a levelwhere it becomes obviously excessive, dispro-portionate and unjustified.16

At the same time, the requirement of perform-ance-based taxation17 can also be interpretedfrom Article 70/I. Although universality, equali-ty and proportionality are taught at Hungarianlaw schools as the constitutional principles oftaxation, it can be drawn directly from therequirement of both equality and proportionali-ty that entities with identical economic per-formance should be regarded identically, andthat entities with higher economic performancecan or should be taxed at a higher extent. In thepractice of the Constitutional Court related tolegal equality, it is remarkable that “anti-consti-tutionality is caused not only when a certain


724

group (in a similar position) is subject to differ-ent regulations (with no constitutional grounds)within the concept of regulations, but it is also adiscrimination when a given regulation conceptis applied identically to groups in considerably dif-ferent positions from constitutional aspects. If noreasonable explanation is to be found for such adamage-inducing action after careful considera-tion, it is to be deemed arbitrary, and thereforeas anti-constitutional.”18

PROTECTION OF MARRIAGE AND FAMILIESIN THE SCOPE OF PUBLIC CONTRIBUTIONS

At first glance, there are several scopes regard-ed by the Constitution as being in differentpositions than others. Marriage and families aredefined primarily, to be protected as institu-tions by the Republic of Hungary (Article 15)and laws related to minors. Accordingly, chil-dren are the only natural persons that have afundamental right to be protected and cared forby the family, the state, and the society asrequired for their appropriate physical, mental,and moral development (Article 67). A familyshould be interpreted as a community compris-ing parents and a child or children, ideally acommunity based on marriage.

Children are human beings eligible to allfundamental rights, but in order to use theserights fully all conditions their age requiresshall be ensured.

Although parents ensure these rights prima-rily, the state and the society both have obliga-tions in accordance with the Constitution. It isthe fundamental obligation of parents to pro-vide upbringing, defined by Article 67 of theConstitution as care necessary for physicaldevelopment.19

Consequently, however, Articles 15 and 67of the Constitution shall be interpreted jointlywith Article 70/I of the Constitution. In otherwords, the public contribution rule of the

Constitution cannot be interpreted as a stand-alone rule but should be regarded jointly withother regulations of the Constitution, includ-ing those defining the fundamental rights andprotection of marriage, families, and minors. Itis because the Constitution prescribes obliga-tions for the parents, the state, and the societyby defining the fundamental rights of children.When describing parents' upbringing obliga-tion, and no such obligation is prescribed forothers, the Constitution impacts parents' per-formance as far as taxes are concerned.Obviously, the economic performance and thetax payment ability of parents that raise theirchild or children in their own homes differfrom childless singles and couples. It is easy torealise the assets to be allocated for theupbringing of a child or children, as prescribedby the Constitution, reduce the amount to beused by parents freely. Because of these tworeasons, parents with a child or children bearlarger public contributions than the childlesseven if tax burdens are identical. This wouldviolate the principle of performance-based taxpayment. The protection of the institution offamilies should mean that families shall not bedisadvantaged by the government in compari-son to those having no children. Citizens livingin families (i.e. raising children) are burdenedby the Constitution with additional obligationscompared to others. The protection and carerequired for the appropriate physical, mental,and moral upbringing of a child have an impactof reducing income and wealth. It is anti-con-stitutional to oblige citizens living in familiesto pay a similar extent of public contributionsas citizens not living in families do.20

The practice of the Constitutional Courtclearly links the institution of families withmarriage. According to the ConstitutionalCourt, “the institution of marriage in our cul-ture and legislation is traditionally a communi-ty formed by a male and a female. This com-munity typically aims to bear and raise children


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within the family in addition to being the back-ground for the couple to live in mutual care andsupport. The ability to father or bear children isnot a component or conditions of marriage,but the spouses must be of different sexesbecause of the original and typical purpose ofmarriage. Constitutional protection for theinstitution of marriage is also granted for thepurpose of furthering couples to create familieswith children.”21

The conclusion can be drawn from the deci-sion of the Constitutional Court that the insti-tution of marriage is regarded as preparationsfor establishing a family and therefore it is tobe protected.

MARRIAGE AND FAMILY IN GERMANY'SBASIC LAW

It is worth taking a brief look at how justices ofthe German Constitutional Court regard fami-ly and marriage, especially since the GermanBasic Law and the Hungarian Constitutionprescribe the obligation to protect the institu-tion of marriage and family identically.

The German Federal Constitutional Court(BVerfG) dictates that the matrimony of a manand a woman shall be regarded marriage.22 It isalso clear from the track record of decisionsdelivered by the German BVerfG (as well as theFederal Public Administration Court, the CivilCollege of the Federal Supreme Court, and theFederal Social Court) that the acknowledg-ment of the domestic partnership is based onthe existence of different sexes therein, theability to establish a family.23 The GermanConstitution, similarly to the Hungarian one,regards marriage the only form of cohabitationto be protected. A typical characteristics ofmarriage is the formation of financial unionbetween the spouses for the duration of themarital cohabitation. Marriage is undoubtedlyan economic unit in which the spouses partici-

pate equally in income creation. Therefore, thetax performance of the couple – the husbandand the wife – is indicated by the respectivehalves of their total income. Consequently,when the tax laws regards marriage as an eco-nomic unit and taxes the income of couples dis-similarly to that of singles by taking their totalincome into consideration and splits it equally,the government does not provide tax allowancebut executes the marriage protection directiveof the Constitution.24 In January 1984, theFederal Court of Switzerland, also acting as aconstitutional court, reached the decision thatmarried couples shall be burdened less in termsof taxes than singles are and cannot be bur-dened more than couples living in cohabita-tion.25 The Federal Court has established thatit is anti-constitutional to discriminate double-income couples against those in cohabitation interms of taxes if their positions are comparable.

As for constitutional considerations, thedecision of the German Constitutional Court26

should also be underlined that focuses on pub-lic contributions related to nursing insurancebut the principle outlined in the decision – theconstitutional requirement of obliging thechildless to pay higher contribution, and con-tribution payers have to be exempt from con-tribution payment if they already have at leastone child or when their first child is born –could have far-reaching ramifications.

In Germany nursing insurance is a servicewith several beneficiaries typically. Personsgiven nursing are beneficiaries, but familymembers living with the patient or takingresponsibility for nursing other ways are alsogiven help. Implemented as of 1 January 1995,the system required the insured to pay a con-tribution of 1.7 per cent irrespective of havingchildren. This status quo was challenged by theGerman Constitutional Court. The courtargued that those who were raising at least onechild had made individual contributions, there-fore their contribution could not be identical


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to that of the childless. Taking this considera-tion further, the questions can be raised thatthose raising one child should pay differentrates than those raising three, four or five kids;and that those that have no children as a resultof a conscious decision should pay more in thescope of pension and health insurance?27

FLAT TAX AS A PROGRAM

The conclusion that Hungary's tax systemneeds changes may also be drawn from the factthat each political party addresses some issuesof a tax reform, which also took centre stage inthe election campaigns of the most recent gen-eral election in 2006.

Some circumstances that are quite controver-sial should be addressed here as the solution forthem should perhaps be delivered by a future taxreform. In Hungary, nearly 100,000 micro busi-nesses choosing EVA (Simplified EnterpriseTax) pay nearly 25 per cent of the total paid bythe other 1.3 million economic entities regis-tered by the KSH (Hungarian Statistical Office)in Hungary.28 According to the most recent taxstatistics, three out of five private entrepreneursand one-third of companies (106,000 compa-nies) do not generate profits. Last year, onpaper, one out of every four persons – totallingnearly 1.2 million – earned minimum wage orless; an indication that they cover their suste-nance from minimum wage and other untaxedincome, provided the data in their tax returns aretruthful. This scope used so much tax deductionand other tax refunds that at the end of the daythey were responsible merely for 1.9 per cent ofall personal income tax paid. A remarkable data,the average tax burden of micro businesses andsmall and medium enterprises was 15.6 per centlast year with a 16-percent corporate tax, whilelarge corporations paid 9.7 per cent on average.29

Looking at the numbers solely, the tax paymentability of small businesses in Hungary is appar-

ently bigger than large corporates'. Obviously,it's no coincidence that among OECD memberstates Hungarians paid the second-highest rateof tax and contributions last year, 54.4 per cent.Taxpayers in Belgium pay that much, but atHUF 610,00 their average salary is four timeshigher than the Hungarian average.30

The most significant tax policy proposal putforward by the then government party SZDSZ(Alliance of Free Democrats) in the 2006 cam-paign was to implement flat tax, a uniform 20per cent for VAT, Personal Income Tax, corpo-rate tax, and pension contribution. SZDSZ saidthe biggest advantage of this design would besimplify taxation, possibly eliminating trickeryand loopholes.

Minor opposition party MDF (HungarianDemocratic Forum) promised an 18-percentflat tax in personal income tax, the eliminationof capital gains tax, and no implementation ofinterest tax. However, both major parties –government party MSZP (Hungarian SocialistParty) and opposition force Fidesz (Alliance ofYoung Democrats) – rejected the idea of a flat-tax system, saying the current tax regime,where wealthier people paid a higher percent-age, was fairer from a social point of view, anda 20-percent flat tax would mean a tax hike forthose currently in the 18-percent bracket.31

By now it has become part of the agreementbetween the government coalition parties that,after an interim period, a flat tax system, ensuringmore transparent and simpler tax payment, wouldbe implemented in 2009. The concept indicates a20-percent flat tax,32 while the issue of fairnessseems to have been relegated to the backseat.

INTERPRETATIONS OF FLAT TAX

What is a flat-tax system? This concept meansvarious, different, tax designs. It is a standardisedtax rate applied for a homogeneous tax basis; aproportional tax. In terms of income taxes, how-


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ever, a tax is usually meant by it which is not pro-portional but incorporates an income limit fortax exemption. In this case income beyond thatlimit is taxed. The combination of tax-exemptincome and a uniform tax rate applied for incomebeyond that limit indirectly results in progressivetaxes. The average tax rate on income just a bithigher than the limit is near zero, while highincome are close to the constant tax rate.33

A study prepared by the Hungarian Ministryof Finance34 underlines that a proposal for aflat tax was first developed by Robert Hall andAlvin Rabushka in the early 1980s, so the ideaof flat tax comes from the United States. Theproposal suggested every dollar of incomeshould be taxed at a standardised rate of 19 percent with the exception of family income belowUSD 25,000, which should be exempt from tax.They argued that this simple taxation designwould contribute greatly to economic develop-ment, because substantial clerical costs couldbe saved. Rabushka said such a system would infact eliminate the need for tax returns, becausethe flat tax could be withheld when each unit ofincome was produced, saving the time and costto calculate taxes and file tax returns as well asconsiderably simplifying tax control. Counter-arguments concerning fairness were not justi-fied, said Hall and Rabushka, because theobjectives of social policy should not beachieved through taxation. According to theMinistry of Finance study, OECD distinguish-es between four flat tax designs:

• flat tax without tax exemption (Georgia), • flat tax with tax exemption (Russia), • flat tax with tax refund, and • standard rate extended to corporate taxes

as well. In the background of the concept of flat tax

there is Arthur B. Laffer's famous and much-debated theory which seeks to find some con-nection between tax rates imposed by the gov-ernment and the size of the tax revenue col-lected by the treasury.35 The Laffer Curve

graphically displays the connection betweentax revenues and tax rates. The graph showsthat the size of tax revenues initially increase ata relatively fast pace as tax rates are increased,but then growth slows down and revenuesreach their maximum at T*. When the tax rateis higher than T*, people respond by eitherreducing their work performance or evadingtax payment, resulting in lower tax revenues. Ifthe tax rate amounted to 100 per cent, every-body would stop working and revenues woulddecrease to nought. The Laffler analysis alsoshowed that a government has two choices asfar as taxation is concerned. One, imposinghigher taxes on a small percentage of the popu-lation, or doing the opposite by applying lowertaxes but to a wider tax base. The Laffer Curvealso indicates two theoretical tax rates for thesame tax revenue, a high and a low rate.Consequently, state revenues do not necessari-ly decline when lower tax rates are employed.36

While flat tax existed in Hong Kong and taxhavens like the Channel Islands earlier, nowa-days a victory parade has been witnessed, albeitin Easter Europe only. Estonia and Lithuaniaimplemented a flat-tax system in 1994, Latviain 1997, Russia in 2001, Serbia in 2003, Slovakiaand Ukraine in 2004, and Romania in 2005. TheCzech Republic, Bulgaria, and Macedonia havebeen preparing to follow suit in 2008.37 Theadvantages of flat tax include positive impactson employment and economic growth, a reduc-tion in tax evasion schemes, and considerablesimplification in the taxation system. On theother hand, flat tax generates problems forthose with low and medium income, becausetheir tax burden increases.

PAUL KIRCHHOF'S FLAT TAX

In Western Europe, the implementation of flattax was considered most seriously in Germanyin the form of a finalised bill. There's no flat tax


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in personal income tax in Western Europe,except for Iceland38 and Greece.39 The Germantax reform is attributed to Paul Kirchhof,40

finance minister candidate in Angela Merkel'selection campaign in 2005. The Christian-Democratic finance minister candidate wascompared by Angela Merkel to Ludwig Erhard,regarded the foster father of Germany's eco-nomic miracle. The debate that had evolvedaround Kirchhof became a substantial factor inthe election because of the tax reform he sug-gested.41 According to the professor ofHeidelberg University, a 25-percent flat taxwould give the slowing German economy aboost to clamber out of near-stagnation. The62-year-old professor likes to use colourfulsimiles to illustrate his messages. According tohim, the current taxation system in Germany is“a fast-growing weed that suffocates the gardenof freedom”. Of the moderately successfulreforms implements by the Schröder adminis-tration he said it was like “a vehicle in such abad shape that makes further repairs absolutelypointless”.

Kirchhof believes it was time to make radicalmodifications in tax laws. Germany has 31 fed-eral taxes, regulated by more than 70,000 arti-cles. According to his proposal, the number oftaxes would be reduced to four, comprising anincome tax, a sales tax, an inheritance tax, and aconsumption tax, and the relevant bulk of lawswould be reduced to 400.

The result of three years of research andpopularly know as Einkommensteuergesetz-buch (EStGB42), Kirchhof's concept focuseson the idea that return taxes, i.e. taxes onincome, should be standardised on legal basis ina transition period spanning 2 to 4 years. Allincome are managed as one irrespective of itsorigins, i.e. wages, interest, lease, or corporateearnings. Differences stemming from differentcost-deduction rules related to various taxassets will be eliminated. EStBG would expandthe tax base, and in addition to natural persons

“tax-law entities” will also be included in it.“Tax-law entities” are a concept independent ofcivil law. It comprises all sole proprietorships,separated assets, and capital ventures (econom-ic entities), replacing corporate tax completely.Opportunities for tax evasion stemming fromcorporate restructuring are eliminated; tax dif-ferences between various enterprise forms arealso eliminated. All tax deductions and exemp-tions are also eliminated, causing a considerableexpansion in the tax base. Marital splitting(when spouses combine then halve theirincome) would also be changed as spousescould now consolidate their respective tax-freeincome.

Natural persons could deduct up to EUR2,000 as flat-rate costs from their income.Minimum sustenance would remain untaxed.All taxable persons and dependents, all childrenare entitled to tax exemption up to EUR 8,000,to be used by the married parents of thedependent child. Sixty per cent of the nextEUR 5,000 bracket is taxed, and 80 per cent ofthe next EUR 5,000, which means the full taxat 25 per cent is only applied for incomebeyond EUR 20,000.

The flat tax system proposed by EStGBmakes lengthy browsing of tax laws, the seek-ing of tax advisors and finding ways of tax eva-sion unnecessary. While the governmentpresently not only demands money from tax-able persons but deprives them of a lot of timeby forcing them to study receipts often collect-ed in shoe boxes, as well as tax law explanationsand tax tips, the proposed tax reform wouldrelieve them from all these obligations.

On the basis of one of the books authoredby Kirchhof43 – voted the best literature inSeptember 2005 – it is beneficial to take a closelook at the legal considerations behind EStGB.

The author, on the basis of constitutionallaw, rejects the role taxes play in economic pol-icy, emphasising the financing role of taxesinstead. Its legitimacy is established by the


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concept that income usually and obviously issubject to the community and the legal andeconomic environment provided by the com-munity. In these cases, the state, acting as therepresentative of the community, may demandpart of the income by way of taxes. Forinstance, a thriller could be written in a singleday and may reap huge success in the marketand generate a huge income, while anotherbook, this one on tax reforms, is written forthree years night and day and received by themarket differently, although it may even bemore valuable for the community in spite ofbeing judged by the market as an unsuccessfulpublication. The progressive design of taxesstems from this idea: Those making a largerincome use the market and the conditions pro-vided by the state more intensively, thus theparticipating community may have higherdemands.

The state earns its funds differently than pri-vate economy where income is generated bythe direct exchange of output. The state is nota market player directly. Its services, ensuredfor the greater good of the entire society, aretransferred not amid market conditions. Thefinancial and economic impartiality and sover-eignty of the state is protected by the fact thatit finances its operation by taxes. Taxpayersthat pay higher taxes have no stronger clout onthe operation of the state or the legislation thanthose paying less, and vice versa, the govern-ment does not prefer major taxpayers to minorones. Strict separation of government revenuesand expenditures is one of the focal points ofthe German Basic Law. Ever since the MagnaCharta Libertatum and the taxation policy laidout by the second political will of Frederick theGreat the constitutional conclusion of the statepolicy concept that sets out from limiting tax-ation rights and protects taxpayers by prohibit-ing excessive taxes and prescribes that the larg-er part of income should remain with thosewho earn it44 has been the concept of taxation

in proportion to performance, the prohibitionof confiscation-type taxes, and the requirementthat taxes should be on par with income andwealth.45

Tax benefits described in tax laws and statesubsidies granted by way of tax benefits alsorepresent the government's commitment tosupport conduct desirable for the governmentand hampers undesirable conduct. In thesecases, taxes not only ensure revenues but act asa tool of control while tax benefits have to bepaid by other taxpayers at their own expense inthe form of higher taxes, supporting activitiesor organisations they would never support asthey would rather spend their funds on theirfamilies or enterprises they trust. Using taxesas a control tool is a controversial issue,because in these cases their role of ensuringrevenues are demoted; taxes efficient as controltolls cannot be efficient in terms of govern-ment revenues.46

However, the fairness of taxes above allmeans equality, the lack of tax privileges. Taxesare the price of economic freedom and do notlimit freedom, but, on the contrary, are theexpression of freedom.

Historic experience, especially the history ofCentral and Eastern Europe and the formerSoviet Union, indicates that countries withcentral economic management do not needtaxes, but in these countries property is notheld freely and there's no economic autonomy,either.47 But wherever property and enterpriseare free, coverage of government spending canonly be ensured by taxes. Government subsi-dies provided through taxes raise the issue oflimited competition and government subsidies,as well.

From the aspect of constitutional law, theother issue is the requirement48 that tax lawsshould be irrespective of organisations, whichmeans taxes should be independent of whatform of incorporation is used, or not used, torealise income.


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Tax legislation has to regard the fact thatGermany has one of the worst fertility rates inthe world, taking 181st place in the ranking of191 countries. Unless the current trendschange, its population of 81 million will dropto 65 million by 2050. A typical data, 44 percent of the population holding higher educa-tion degrees are childless. Germany's cultural,economic and political future is fundamentallyis at risk. Tax legislation must help Germany'sfuture become open. A change in values shouldbe done to make people care more about theirfamilies and children than the size of theirincome. Also, the misconcept that the emanci-pation of women can only be realised throughbusiness and professional career should be dis-posed of. Families are communities of humanbeings entitled to dependency and of thoseobliged to sustain them. Children demand partof their parents' income. This title of the chil-dren and the obligation of parents are derivedfrom the Constitution49. It is anti-constitu-tional to disregard the additional obligationsincurred to those raising kids when definingpublic contributions, because it violates theprinciple performance-based taxation, and therequirement of imposing taxes on the basis ofwealth and income. A tax which disregards theconcept that the raising of children is not justan individual commitment, but the interest ofthe entire society. Those taking this responsi-bility cannot be disadvantaged in terms of taxescompared to those without it, because the tax-ability of the latter scope is higher than thosewith kids. In the case of equal taxes, thosewould be at a disadvantage who act for the ben-efit of the state.

POTENTIAL IMPACTS OF EStGB

Using a micro-simulation method (FiFoSiM),the Financial Research Institute of theUniversity of Cologne has scrutinised the

redistribution impacts of flat taxes, particularlythe Kirchhof bill.

The impacts of various flat tax propositionshave been scrutinised by various micro-simula-tion studies in terms of how flat taxes impactthe distribution of tax contributions regardingvarious income groups in the current statusquo. Such analyses are significant not onlyfrom a scientific aspect, but politically as well,because the outcome of a comparison mayimpacts the chances of implementation.

The research institute has developed its ownmicro-simulation model50, which aims toanalyse impacts on growth, redistribution, andemployment by using tax statistics as well associal and economic data.

The model comprises two parts: A micro-simulation model of Germany's tax and redis-tribution system and the supply model of thelabour market estimated on the basis of eco-nomic calculations. As a special feature, themodel is based on a twin database. One of themuses roughly three million entries randomlyselected by various criteria from the federalwage and income tax statistics of Germany. Theother incorporates a social and economic sur-vey made in 2003 that comprised 12,000 house-holds or 30,000 individuals. The former is usedto describe groups of taxpayers and income byvarious criteria, and the latter helps calculatenet income of households.

According to the findings of the survey51, acommon feature of flat taxes is the widening ofthe tax base, an increase in non-taxed incomecap, and a relatively low, standard tax rate.Various designs for flat-rate tax reform havedifferent impacts on income distribution, but aflat tax increases income inequalities overall.Particularly the middle class as well as employ-ees outside the scope of self-employment andpensioners – accounting for the majority of thepopulation – would be set back by the imple-mentation of a flat tax, while the upper ten percent of the population with the highest income


731

– particularly those making their living fromself-employment – would benefit from it.

According to the analysis, reforms to imple-ment flat taxes would increase social inequali-ties, and the Kirchhof model has an impact ofincreasing income inequalities.

At the same time, it can also be discerned ingeneral that the higher the untaxed incomelimit and the tax rate, the lower the inequalityincreasing impacts of a flat tax.

Although similar studies in 1985 predicted afive-percent increase in jobs in the UnitedStates and a two-percent bump was expected inGermany in 2003 – positive impacts of a flat taxsystem on labour market cannot be verifiedunequivocally. Even if there is such an impact,it is likely to be insignificant. Impacts oninvestments and employment are theoreticallysubject to the applied tax rate and the situationon the labour market at the time.

It is to be noted that Table 4 of the surveysuggests that on the basis of the Kirchhofmodel – when taking the demographics of win-ners and losers into consideration – 81.77 percent of individuals between the ages 35 and 50and 70.67 per cent of citizens between 55 and65 years would benefit from the implementa-tion of EStBG. It should be similarly notedthat the results of the survey conducted on thebasis of family status indicate that 90.12 percent (!) of married couples raising childrenwould benefit from the implementation ofEStBG, whereas 54.44 per cent of singles withno kids could boast the same.

Obviously, married couples with more thanone child would especially leverage from theKirchhof-model.

Interestingly, one of the biggest losers ofEStBG are taxpayers whose main incomecomes not from work but from equity. Theytake runner-up position among losers with47.73 per cent according to Table 5, only pre-ceded by over-65 citizens with 49.15 per cent inthe age breakdown.

Based on their income, households are divid-ed into ten categories. The lowest tenth has thestrongest income position, and the highesttenth has the weakest. Based on Table 5

• in the first four classes of households (40per cent of less affluent households) theratio of losers is under 20 per cent (in thefirst class, the poorest, this ratio is 0.02 percent),

• the fifth tenth has the highest ratio of los-ers at 22.21 per cent, and

• this ratio decreases but stays above 20 percent up to the ninth tenth, but

• the households with the highest incomewould have a loser ratio of 19.04 per centonly.

ARGUMENTS AGAINST EStGB

Many are against Kirchhof's proposition.52

One of the weightiest reasons cited by thoseagainst a flat tax system is its unfairness.According to their view, a flat tax would meanhigher taxes for the poorer in a multi-bracketprogressive system, and it would be a tax cutfor the more affluent because of eliminating ahigh tax rate. Sceptics argue that tax the princi-ple of performance-based taxes at the sametime means income taxes should be progres-sive, obliging the more affluent to pay morethan the less well-to-do.53

According to the majority of sceptics, a taxreform would surrender the basic principle ofperformance-based taxation. A secretary wouldbe taxed at the same rate as the chairman of asupervisory board. The taxation system wouldlose the role of a social equaliser, and taxeswould no longer regroup income. A survey54

released by the managing board of IG Metall55

indicates that the net annual income of a singlehead nurse with an annual salary of EUR 34,500would be EUR 1,010 less, suffering a 4.3-per-cent slump in income. A family with two kids


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where both parents are blue-collar workers withone of them working part-time and earning acombined EUR 52,500 annual income wouldsuffer a loss of EUR 1,266, representing 3.1 percent of their income. As a contrast, a managerwith no spouse and no children earning EUR65,000 annually would make EUR 4,765 or 12.5per cent more. The income of a manager whosespouse is a housewife with two kids and earningEUR 208,000 annually would be 9.4 per centhigher when flat tax is implemented. These fig-ures clearly show that high-income individualswould benefit from a tax reform.

Sceptics – including DIW56 according to anewspaper article – expect the central budget tolose EUR 26 billion if the Kirchhof model wereto be implemented. Flat rate tax would clearlylower the tax rate, especially in the scope ofhigher income and would cause lower burdens– both in relative and absolute terms – for thisscope than in the scope of average wages.Surveys indicate that the abolition of all taxdeductions and tax subsidies would increasethe tax basis by no more than 12 per cent while14.5 per cent could be achieved by putting aheavier burden on business earnings.According to surveys, the tax contributionspaid by 'the wealthy' are substantial in thescope of income taxes, financing a considerableratio of government expenditures. Ten per centof the wealthiest taxpayers are responsible for51 per cent of income tax revenues, and thetopmost 0.1 per cent – representing 29,000individuals – account for 8.3 per cent of incometax revenues.

POTENTIAL IMPACTS OF FLAT TAX IN HUNGARY

Impacts of a flat tax on the redistribution sys-tem in Hungary have also been surveyed.57

The survey is based on the concept that thegovernment has a number of tools to execute

redistribution. One of these pillars is the taxsystem, which can be regressive, linear, or pro-gressive. Income tax systems are generally pro-gressive, but tax deductions modify the degreeof progression, and indirect taxes complicatethe system further. The other major tool usedin redistribution is the system of social trans-fers, which comprises universal or eligibility-based benefits. Income redistribution inHungary is also demonstrated by micro-simu-lation, using the micro-simulation modelTÁRSZIM-2005 devised by the Ministry ofFinance. One of the core components of themodel is an individual-level database thatdescribes the composition of the society andthe characteristics of its members well, makingit representative and aptly detailed. The data-base is built on a compilation by the TárkiMonitor in 2004, containing the individualdemographic data, labour market characteris-tics, and income figures of 2,325 Hungarianhouseholds surveyed in 2003, as well as themain characteristics of the households. Thiswas supplemented by the database of KSHHáztartás Költségvetési Felvétel [HungarianStatistical Office Household Budget Survey] of2003, which contains detailed consumptiondata of nearly 8,000 households. The thirddatabase is an APEH [Financial and TaxControl Authority] random sample of nearly62,000 individuals taken from income taxreturns for the year 2003.

The other core component of the model isthe system of taxes, contributions, and bene-fits. What the study establishes of the statusquo scrutinised on the basis of regulationseffective in 2006 is that tax deductions accountfor a substantial sum in the Hungarian systemof taxes and benefits, but they fail to reach thereally needy, favouring those with medium-sized income instead. As a contrast, cash bene-fits are delivered to the poorer third of house-holds primarily, increasing their income sub-stantially. The system reaches families with


733

children efficiently, and the significance of ben-efits increase when the number of children arehigher.

The implementation of a flat tax would mod-ify this redistribution system. In addition todescribing the current situation, the studyexamines the potential redistribution effects ofa flat tax by using an imaginary tax regimewhich is less complex than the current regimeand similar to the one implemented in Slovakia.In this imaginary system tax rates are standard-ised at 20 per cent (both for Personal IncomeTax and Value Added Tax), and all incomewould be included in the consolidated tax basis,but employees' tax rebate and the supplemen-tary tax rebate ensuring no taxes for minimumwage would remain in place. Apart from that,there would be no other tax deductions or gasprice subsidies, but income-based benefitsmanaged by the municipalities as well as insur-ance-based transfers and family benefits (fami-ly benefit, maternity benefit, and maternityallowance) would remain in place.

Also operating with ten income brackets,the study also identifies winners and losers inthe income groups, establishing that the uni-versal 20-percent flat tax would be beneficialfor higher-income individuals. Althoughthere are no huge discrepancies in tax pay-ments except for the upper 20 per cent of theincome range, tax burdens would be signifi-cantly lower for the wealthiest. Personalincome tax for the entire family in the upperhalf of the income range would be lower, butVAT paid would increase for all ten incomescopes (this latter is an obvious consequenceof the elimination of the preferential VATrate). The more affluent would benefit fromthe combined result of these factors, andpoorer strata would emerge as losers. Overall,the income of the upper third would increase,but the lower half would have to do with lessdisposable income. Roughly 15 per cent ofhouseholds would benefit from a flat tax

regime and 15 per cent would be at disadvan-tage, and the rest would not experience sub-stantial changes. Winners come from theupper income range, and the rate of losers isover 10 per cent in each group, but the distri-bution is highest in the middle range.Compared to the current system, the imple-mentation of such a tax regime would reducethe extent of income regrouping, hence socialsolidarity. Expectations suggest that theimplementation of a Slovakian flat tax inHungary would be beneficial for well-to-dohouseholds primarily and would make poorerone the losers. The main reason for that liesin the reduction of the highest tax rate in thescope of personal income tax and the impactsof the VAT consolidation, increasing theexpenses of households.

CLOSING CONSIDERATIONS

A flat rate tax means a more transparent andmore intelligible tax system, provided it focus-es on a single tax rate, the elimination of alldeductions, the implementation of a wider andstandardised tax base.

Its fairness cannot be assessed in itself. Themain reason is that its most frequently criti-cised flaw – preferring the more affluent andcausing disadvantages for the poorer strata – islargely subject to the economic environment58

and the legislative details, including the size ofthe tax-free income and the extent of the taxrate.59 Flat tax is also suitable to express anumber of constitutional requirements orpolitical objectives. However, the argumentagainst it – that it would eliminate progression– is true in formal consideration only.Although higher income would not be taxed ata higher rate, progression would still prevail:In the Kirchhof model the 25-percent rateimpacts income over EUR 20,00060 but leavesincome below that intact.


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1 http://www.unesco.hu/index.php?type=node&id=131

2 A társadalmi fenntarthatóság mérése – Módszertanitanulmány [Measuring Social Sustainability – A Studyin Methodology], Társadalomtudományi munkacso-port [Social Sciences Working Group], Ms. Bodorkós,Barbara – Pataki, György – Ms. Vári, Anna,http://www.kep.taki.iif.hu/file/Vari_ Tarsadalmi_fenntarthatosag_ indikatorai.doc

3 1st on the list Niger with 50.16, Ireland 151st with14.40, France 162nd with 12.91. Source: https://www.cia.gov/library/publications/the-world-fact-book/rankorder/2054rank.html

4 Article 70/I: "All natural persons, legal persons andunincorporated organizations have the obligation tocontribute to public revenues on the basis of theirincome and wealth."

5 620/B/1992 ABH 1994, 539, 541.

6 61/1992. (XI. 20.) Constitutional Court Decision,1992, pages 280, 281.

7 122/B/1996 Constitutional Court Decision, 2002,pages 737, 746.

8 54/1993. (X. 13.) Constitutional Court Decision,1993, pages 340, 342.

9 61/2006. (XI. 15.) Constitutional Court Decision,2006, page 674.

10 Pallas Nagy Lexikona [Pallas Great Encyclopaedia]

11 Földes, Gábor: Tax Legislation, Osiris Kiadó[Osiris Publishing House], 2001, page 127

12 620/B/1992 Constitutional Court Decision, 1994,pages 539, 541.

13 61/1992. (XI. 20.) Constitutional Court Decision,1992, pp 280, 281.

14 The 'Addendum' of the Pallas Nagy Lexikon dated"In the Month of Christmas 1897 in Budapest"

15 This requirement can be found in the practice ofthe German Constitutional Court. For instance,the rule of German Constitution prescribingspecial government protection for marriage and

families (GG Art. 6 Abs.1.) means in practicethat sustenance amounts for each family mem-ber should be left untaxed in the case of familytax. See also: Beschluß des Zweiten Senats vom10. November 1998 – 2 BvL 42/93 – In accor-dance with the practice in Germany, the govern-ment is obliged to leave taxpayer incomeuntaxed up to the extent necessary for the min-imum of human existence (Existenz-minimum)BVerfGE 82, 60.

16 Constitutional Court Decision, 1992. page 506.

17 In the practice of the German ConstitutionalCourt – even though this principle is not linkedto a single constitutional rule – is generallyattached to the requirement of equal rights. The'Leistungsfähigkeitsprinzip' can be interpreted asa horizontal effort, putting equal burdens onentities with equal economic strength. See also:Uwe Paschen: Steuerumgehung im nationalenund internationalen Steuerrecht, page 52,http://books.google.hu/books?id=wkKnqqXF1iwC&pg=PA52&lpg=PA52&dq=leistungs-fahigkeitsprinzip+bverfg&source=web&ots=qVVgGCpref&sig=gVs23dH9Tu7CpdjQlIW1M6C2-Nc&hl=hu

18 6/1997. (II. 7.) Constitutional Court Decision,1997, page 67.

19 (995/B/ Constitutional Court Decision, 1993, pp524-525.)

20 It should be noted that child support received on thebasis of obligations defined by the law is tax-free (onthe part of the child), and rightly so. However, sup-port for children given in kind is not exempt fromtax – at least according to the letter of the PersonalIncome Tax Act – although it should be. Some fam-ilies, typically those with divorced parents, a certainpart of the child support (the part to be paid by oneof the parents) is not regarded as income at the fam-ily where the child is actually raised.

21 14/1995. (III. 13.) Constitutional Court Decision,1995, pp 82, 83.

22 BVerfG FamRZ 93/1419

23 BVerfG FamRZ 93/164; BVerfG FamRZ 95/1352;BVerwGE 15/306; 52/11; BGHZ FamRZ 93/533;BSGE 63/120.

NOTES


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24 See also: Professor Dr. Rudolf Wendt: Grundfragender Familienbesteuerung, from page 11, http://wendt.jura.uni-saarland.de/Prof.Dr.Wendt/Vortraege/GfderFamilienbesteuerung.htm

25 http://www.efd.admin.ch/dokumentation/zahlen/00579/00608/00631/index.html?lang=de

26 BVerfG 03.04.2001 – 1 BvR 2014/95; on 3 April2001 six decisions about nursing insurancewere delivered. http://www.versicherungsnetz.de/Onlinelexikon/Pflegeversicherung.html

27 There used to be a childless tax in Hungary, abol-ished after the 1956 revolution (see Part V. of1004/1953. (II. 8.) Council of Ministers Decree,and 8/1953. (II. 8.) Council of Ministers Decree onchildless tax). Beginning on 1 March 1953, malesbetween 20 and 50 years of age as well as femalesbetween 20 and 45 had to pay 4 per cent of theirincome (HUF 15 per month in the case of house-hold employees) in case they did not have a child(biological or adopted or in foster care). Parentswhose child had died after the age of 20 wereexempt from the tax, along with members receivingpay from the People's Army or the NationalSecurity Authority and their wives, as well as thewar disabled at 100 per cent and 75 per cent and thecivilian war disabled, and males and females between20 and 24 years of age until they attended school(university, etc.). Decided after the 1956 revolution,14/1956. (XII. 24.) Government Decree abolishedchildless tax..

28 Explanation of Act CLIII. of 2005 on the 2006Budget of the Republic of Hungary 2006, II. 1.1.

29 http://index.hu/gazdasag/magyar/bevall071115

30 http://www.oecd.org/document/57/0,3343,en_2649_201185_40233913_1_1_1_1,00.html, Table 01.

31 h t t p : / / v a l a s z t a s 2 0 0 6 . o r i g o . h u / v a l a s z -tas2006/20060209ado.html?pIdx=2

32 http://www2.szdsz.hu/hu/szdsz/hirek/20060610egykulcsos

33 Die Flat Rate Tax von Prof. Dr. Clemens Fuest,manuscript by Andreas Peichl dated 6 November2007.

34 Nemzetközi adóreform tapasztalatok [Internatio-nal Experience in Tax Reforms], Szakmai hát-téranyag [Background material], 5 September

2007, prepared by the Economic researchDepartment of the Economic Policy Division ofthe Ministry of Finance on commission byEconomic Compe-titiveness Round-table,http://versenykepes seg. magyarorszagholnap.hu/images/5._%C3%BCl%C3%A9s_Nemzetkozitapasztalatok.pdf, pp 4–5

35 http://de.wikipedia.org/wiki/Laffer-Kurve

36 One of the examples for the 'operation' of theCurve is reduction of Hungary's corporate tax to 18per cent from 36 per cent as of 1 January 1995,which caused not a decrease but an increase in taxrevenues.

37 Remarkably, former Socialist countries are the fore-runners of implementing flat tax in Europe; and,also remarkably, Poland and Hungary, the twocountries where the economic and political transi-tion started, are exceptions.

38 In Iceland, the linear personal income tax was25.75 per cent in 2002. Income is tax free, actual-ly taxed at zero per cent, up to HUF 809.616. A 7-percent supplementary tax is imposed on incomeexceeding ISK 3,980,000 (roughly HUF 12 mil-lion). Capital gains tax is 10 per cent. Available toall, tax deduction equals to HUF 936,000 annual-ly. If the tax reduction is higher than the tax to bepaid, the difference is compensated by the treas-ury. the unused part of singles' tax reduction isthen cancelled. Married couples can add 95 percent of their unused tax deduction to the incomeof the spouse. Tax payment can be reduced by acomplex but detailed set of child benefits (thesum depends on how many children there are, andhow many of them are under 7 or over 16,whether the parent is single, and the parent'sincome is average or above average, because high-er income gets lower tax benefit after the child orchildren). www.es.hu/pd/display.asp%3Fchannel%3DPUBLICISZTIKA0411%26article%3D2004-0316-0955-23SFBH

39 Personal income tax reform in Greece started in2007 and will facilitate a gradual transition to a uni-form 25-percent tax until 2010 and the abolish-ment of existing tax benefits. Since public financedeficit was 6.5 per cent of GDP last year, the objec-tive is to curb tax evasion rather than reduce taxburdens (Athens wanted to push deficit below 3 per cent in 2006 to meet the criteria set forth bythe Stability Pact. http://index.hu/gazdasag/vilag/kulcssz05082/?print


736

40 German expert of constitutional and tax laws, a pro-fessor at Heidelberg University Law School, federalconstitutional justice between, 1987 and 1999,http://de.wikipedia.org/wiki/Paul_Kirchhof

41 "Germany heads to polls on flat tax" FigyelõNet, 17September 2005, http://www.voks2006.hu/index.php?id=4&cid=106239

42 13,122 characters, 23 Sections, no appendices,http://www.bwl-bote.de/20050817.htm

43 Paul Kirchhof: Der Weg zu einem neuenSteuerrecht – klar, verständlich, gerecht DeutscherTaschenbuch Verlag München, September 2005

44 Indirect taxes should also be taken into considera-tion when calculating the 'larger part'. Accordingly,the theoretic 50-percent tax rate should be reducedby the VAT rate. The 25-percent rate in theKirchhof model takes tax burdens imposed by indi-rect taxes into consideration.

45 The latter two principles are also evident in the prac-tice of the Hungarian Constitutional Court. In itsDecision 1531/B/1991., the Constitutional Courtresolved a case where the petitioner found the pro-portional rule of Article 70/I. as being violated by amunicipal decree because the lump sum annual taxon his property had been imposed in a such way thatit was excessive compared to the value of the prop-erty. The Constitutional Court Decision establishedthat although it as not the responsibility of theextent or the sum of the tax, but "when a normativeapplies a public burden that results in the bankrupt-cy of the taxable person, it can lo longer be regard-ed as tax", Constitutional Court Decision 1993.,pages 707, 711. In other decision it was establishedthat when the tax extent is so excessive in compari-son to the underlying value (the market value of theproperty) that it is regarded as confiscation, then itwould be anti-constitutional. The same reasoningwas applied in its Decision 25/2005. (VII. 14.)regarding stamp duties.

46 The example of the tax on petty cash also demon-strates that no revenues would have been made hadthe tax achieved its goal, because the objective wasto keep cash in petty cash below a certain percent-age of sales. Cash beyond that limit were te betaxed, but no taxes were to be paid on sum belowthe cap.

47 It is to be noted that the first tax reform in Hungarywas based on laws coming into force in 1987 and

1988, which means the implementation of VAT, cor-porate tax, and the law on corporations precededthe political and economic transition. PéterGosztonyi writes in his book A magyar Golgota[The Hungarian Golgotha] (Százszorszép kiadó[Százszorszép Publishing], Budapest, 1993) thatParty Committee Secretary János Berecz said in aninterview in the second half of March 1998 thatGromiko, the then Foreign Secretary of the SovietUnion, had warned them: deep changes were to beexpected both politically and economically, becausethe Soviet Union was going to give up her EasternEuropean positions (pp 241–243). Gosztonyi saysthe collapse of the Communist regime did not cameas a surprise for party leaders. "Time will tellwhether they used the warning appropriately".

48 According to a decision by the GermanConstitutional Court (Schwarzwaldklinik,BVerfGE 101, 151) neither the legal or the incorpo-rated from of an enterprise may lead to different taxburdens. The freedom of association prohibits thetax legislation to affect the right to free choice offorms of incorporation. The decision projects afuture resolution that personal enterprises and cap-ital corporations are to be considered as equal by thetax legislation.

49 The Hungarian Constitutional Court considersArticle 67 (1) of the Constitution, prescribing thecare obligations of parents and the state, as one ofthe fundamental rights of children; ConstitutionalCourt Decision 576/D/2000, 2006, page 1314

50 Dokumentation des Wohlfartsmoduls vonFiFoSiM, Frank Brenneisen und Andreas Peichl,FiFo-CPE Discussion Papers, No. 07.04., 2007

51 Die Flat Tax: Wer gewinnt? Wer verliert? Eineempirische Analyse für Deutschland von ClementFuest, Andreas Peichl, Thilo Schaefer, Juli 2006,Finanzwissenschaftliche Diskussionsbeiträge Nr. 06–6

52 Including Prof. Dr. Stefan Homburg (1961), pro-fessor of Leibniz University, Hannover, and chair-man of Public Funds Institute, member of the fed-eral Finance Ministry's Scientific Council between1996 and 2003; and Prof. Dr. Rudolf Hickel,researcher for Institute for Work and Economy(IAW), professor of economics at the Universityof Bremen, who authored the study "Kirchhof'sConservative-Liberal Guide to Taxes: TaxSimplification Simply Causes Unfairness in TaxContributions and Renders the State Poor" inSeptember 2005.


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53 The outcome of the general election in 2005proved catastrophic for Angela Merkel'sChristian-Democrats, who had clearly been losingin the polls during the entire election campaign.Observers find it likely that many voters werecompelled to reconsider their positions by theradical reform concepts of Merkel's shadow finan-cial minister, Paul Kirchhof. http://www.bbc.co.uk/hungarian/news/ story/2005/09/050919_ger-many_election.shtml

54 One of the largest trade unions of the world, com-prising nearly 2.3 million employees in metallurgyindustry, textile and clothing industry, and timberand plastics industry.

55 Wirschaft aktuell 13/2005 – Aktuelle wirtschaftpoli-tische Analysen der IG Metal

56 Deutsches Institut für Wirtschaftsforschung,Netzeitung.de, 7 September 2005

57 Közgazdasági Szemle [Economic Journal], yearLIII., July-August 2006 (pp 604–623) Ms. Benedek,Dóra – Ms. Lelkes, Orsolya: A magyarországijövedelem-újraelosztás és egy egykulcsos adóre-form vizsgálata mikroszimulációs modellel [Study

of Income Redistribution and a Flat Tax in Hungaryby Micro-simulation Model].

58 Obviously, a flat tax has different impacts and rea-sons in each country. Flat tax systems are generallyimplemented in economies where – using a bit ofsimplification – it was all or nothing, either becausethe economy was in such a bad shape (Estonia), orbecause progressive taxation had been so ineffective(Russia). A flat tax means a totally different thing inan economically developed, strong country with anextensive and well-operated benefit system. InGermany, the child care benefit (Kinder betreu-ungsgeld) alone is EUR 800 per month until thechild reaches 1.5 years of age, EUR 624 until twoyears, and UER 436 until three years of age – appli-cable up to a limit of EUR 16,200 annual income. Asa comparison: In Hungary, minimum wage is HUF69,000 at the moment, average pension will be HUF85,000 in 2008, and the minimum of old-age pen-sion is set at HUF 28,500.(!).

59 The rate ranges from 13 per cent (Russia) to 33 percent (Lithuania). Both countries can boast successin the implementation of a flat tax system..

60 EUR 1,666.6 per month.

BIBLOGRAPHY REVIEW – Books

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WWith the 2006 elections completed, there wasfirst a debate on the desirable economic policy,followed by the events of 2007-2008, and it wasafter the conclusion of these events that PéterMihályi published the book (2008) that I amsupposed to write a review on hereby butwhich I can provide only an opinion paper on.The two main starting points of the debate fol-lowing the 2006 elections and preceding theevents or at least the decisive part thereof, wasan article by Lajos Bokros, Tamás Bauer, IstvánCsillag and Péter Mihályi (2006) as well as abook by István Csillag and Péter Mihályi(2006). Discussing the above article of the fourauthors, the reviewer published an opinionpaper (Szakolczai, 2006a) – alongside withmany others, whose articles are not to be dis-cussed here not for lack of merit but for lack ofspace – to which articles there was no reply.The reviewer also published an opinion paperon the above book of the two authors

(Szakolczai, 2006b), to which – what is veryimportant – there was a reply (Csillag –Mihályi, 2007), which latter the reviewer, again,gave a due response to (Szakolczai, 2007). Thetwo authors' reply and the reviewer's responseto the reply were published in issue 2007/1 ofthis journal, whereby the debate of principlestopped. It was this debate of principle that thebook of Péter Mihályi (2008) returned to, andthe reviewer is to follow hereby by the currentopinion paper.

The response to the reply that concluded theprevious phase of the debate of principle sum-marised the agreements of opinion between theauthors and the reviewer in ten points first ofall. This agreement of ten points is most signif-icant (for the exact quotations and sources, cf.the original). Individuals should be encour-aged to make savings. Although we mustpreserve our traditions, we must radically mod-ify certain elements of it, like the attitude of

Péter Mihályi

Why is theHungarian economy poorly?Diagnosis and therapy

HVG BOOKS, 2008


739

“leaving our debts to our grandchildren”. We must be successful in the competition ofwinning over investors. The implementationof stabilisation and reform should not be drawnout at will: immediate action is necessary. The reforms require wide social support. The transparency of public finance is a require-ment of primary importance. The generalgovernment should have an accounting systemcapable of monitoring not only currentchanges but also changes in assets. TheMaastricht criteria are arbitrary rather than sci-entifically proven but, as long as these rules ofthe game are applicable, we must follow them.

We must stick to the appropriations relatedto the convergence programme until experi-ence and calculations prove it necessary tomodify them. Without a plan made with acool head and the implementation thereof, ourproblems cannot be solved. – This wide-scaleagreement could have led to a successful policybased on wide-scale agreement; we know that,unfortunately, this has not been the case, how-ever.

Despite these important and wide-scaleagreements of opinion, there were also deepdisagreements of opinion and the response to thereply first summarised those referring to thetimeframe of 18 months proposed for the reformsby the two authors as also apparent from thesubtitle of their book (2006). The 18months were not justified by international eco-nomic considerations. The 18 months werejustified by domestic political considerations.

It was the subordination of economic poli-cy to domestic political and election considera-tions that had caused the crisis which haddeveloped by then and it is thus imperative tobreak with such practice. The implementa-tion of the reforms did not appear to be feasi-ble within 18 months from the very beginning.

The latter lack of implementability withinthe timeframe was also confirmed by the unre-alistic nature of the calculations published in

the appendix of the book. The reformscould not be expected to accelerate economicgrowth. As the reviewer opined from thevery beginning, due to the insistence on the 18month timeframe, the reforms could not evenlead to either stabilisation or a better interna-tional judgement of Hungary. The insis-tence on the 18 months, under the reviewer'sabove opinion, raised the danger of a politicalcatastrophe. The insistence on the 18months, under the above opinion of thereviewer once again, also raised the danger of apolitical identity crisis. This concept andpolicy, as similarly outlined in the above opin-ion of the reviewer in the very beginning, wasfurthermore counterproductive in the politicalsense because, instead of the hoped for successat the next elections, it was likely to lead to anunprecedented failure. – Advancing the conclu-sion of this article, predictions could not havecome more true.

The above was followed by further basic dis-agreements of opinion: is the major cutback onthe welfare state justifiable and implementable?Under the reviewer's opinion formulated in thevery beginning already, it was neither justifiablenor implementable, for the following reasons.

It was not proven and has not been provenuntil today that the reason for Hungary's lag isthe relatively large-scale redistribution.

It was not proven and has not beenproven until today that the lower the tax rate,the more we are interested in its proper use – itis rather the contrary that holds true.

The way out of the tax competition isextending legal harmonisation to the restric-tion of tax competition.

There have been numerous arguments,not to be listed here, in favour of maintainingthe welfare state. Under the reviewer's opinion,the positive result of cutting back on the wel-fare state and on the role of the state was andhas remained a preconception unsupportableby facts or scientific arguments.


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It should be emphasised here that, as thereviewer agrees, it is unavoidable to restorebudget balance: this is a necessity well proven.What has not been proven, however, and it isthus, to put it harshly, a preconception, is thatthe only and the desired way to achieve this isby cutting back on the welfare state and on therole of the state.

The third basic disagreement of opinionreferred to any form of a reform dictatorship:should any idea, even a best one, be implement-ed against the will or even without the activecontribution of those affected? The reviewerbelieves it should not; it ought not even to beattempted. Society, as the authors also pointedout, cannot be made happy against their will.The original response to the reply included alengthy quotation by László Csaba on this,who says the following on the issue: “It seemsthat in social sciences the day of experimentingwith and implementing plans conceived at awriting-desk for societies as a whole, in brief,the day of constructivism, is on the decline.”(Csaba, 2007a, p. 7)

• After summarising the main conclusionsof the response to the reply, let us now discussPéter Mihályi's new book (2008b). Right awayin Chapter 1, the Introduction, the authormakes his main postulate clear. He quotesMárton Tardos and Tamás Bauer who, in theearly eighties, said that privatisation wasimpossible. Although Tardos discussed theimpossibility of reprivatisation rather than thatof privatisation, which former was indeed notimplemented, Bauer explicitly wrote that “theelimination of capital ownership, a thirty years'practice, has become an irreversible processthat could only be changed by outer colonisa-tion” (p. 10), and yet, capital ownership hasreturned: privatisation has been implemented.What Tamás Bauer said on colonisation, on theother hand, is very much worth consideration.Mihályi also quotes László Antal, who says: “itis doubtful if, from a fully developed social

security system with historical traditions, onethat society has got accustomed to, it is possi-ble to regress to a much narrower social welfaresystem, since this would generate an abruptgrowth of inequality and social tension, i.e. thisis not an open gate for Hungary.” (p. 12)Mihályi, on the other hand, pointedly arguesthat this is not only an open gate for Hungarybut this is in fact a gate to cross: “in an open,democratic market economy”, we should not“provide incubator protection (….) for thepremature infant” – the phrase clearly referringto the “premature welfare state” (pp. 11–12) –;on the contrary, the welfare state should bedownsized: together with the issue of “generalgovernment balance, these are the key issues ofthe coming years” (p. 12). The author thusargues that privatisation was held impossibleand yet it was implemented; so downsizing thewelfare state should just as well be implement-ed even if some hold it for impossible.

With reference to the response to the replyquoted in length above, the reviewer mustpoint out here in Chapter 1, the Introduction,already that, in his view, Mihályi's main postu-late is not only not to be shared but, consider-ing what has happened in connection with thehealth care reform, this main postulate shouldnot even have been put down, let alone with theimplication that it was something obvious andbeyond doubt. What has happened in Hungaryin the past two years spectacularly proves that“from a fully developed social security systemwith historical traditions, one that society hasgot accustomed to”, it is not possible “toregress to a much narrower social welfare sys-tem”. Yet, just as the agreements of opinionwere listed in 10 points in the response to thereply, basic agreements of view should also bepointed out here, too. Mihályi is absolutelyright saying that “there is approximately 10 percent excess [domestic consumption] (…) toGDP” because of which “sooner or later, in oneway or another, a correction of a similar rate


741

will be (…) necessary” (p. 11). This is beyonddoubt, as the reviewer has also pointed out inseveral works that are not to be referred tohere, so in this respect there is an absoluteagreement of opinion between the two of us.“Sooner or later” – sooner rather than later ; “inone way or another”: the main question iswhether in this way or another, i.e. what is theway; this correction, i.e. ending domestic con-sumption beyond our means, is inevitable. In thisrespect, I am in absolute agreement with theauthor, while, as pointed out before, I do notconsider it proven, on the other hand, that theonly alternative for this correction could belargely diminishing or almost eliminating thewelfare state. This basic, conceptional differ-ence of opinion must be underlined, pointedlyand clearly, in Chapter 1, the Introduction,already.

Chapter 2: Reform – why now? – is devot-ed to the timing of the reform and this is wherewe should refer back to the antecedents. Intheir article entitled “Last Chance” (2006),Lajos Bokros, Tamás Bauer, István Csillag andPéter Mihályi say the following : “In the sec-ond third of the year 2006 (from May until theend of August), all important bills related tothe public finance reform must be worked out.In the third third of the year (from Septemberto New Year's Eve), Parliament must discussand pass these bills.” This article thus set out aneight-month timeframe for “all importantbills” to be passed. The scheduling is somewhatmore modest in the book of István Csillag andPéter Mihályi (2006), since the book bears thesubtitle “The eighteen months of stabilisationand reforms”, while political considerations aremore overtly expressed here: “The question isif there will be a political situation, if there willbe a government with ministers who, workingtogether as allies, are able to carry out in 18months what they know, deep in their souls,must be carried out. And then they will stillhave 30 months left to prepare for the next

election battle.” (p. 96) The above formulationthus reveals that the scheduling of the reform isclearly subordinated to election considerations:the reforms should be implemented within 18months so that the 30 months thereafter couldbe enough for electors to forget it all and to re-elect the government. Finally, with not 8 or 18months but as many as 26 months havingpassed, Chapter 2 of Péter Mihályi's new book(2008), under the title “Reform – why now?”begins as follows: “As dream books of politol-ogy suggest, it is not advisable to initiate com-prehensive reforms in the middle of a four-yearparliamentary cycle, let alone at a time ofminority government. There is no need to dis-cuss here the strong arguments supportingthis. It is the opposite that would need anexplanation.” (p. 17) And there is an explana-tion to follow here, coming to the final conclu-sion that “it is only at times of crisis when soci-ety can be expected to accept genuine reforms.We have nearly got there already.” (p. 21)

So here we are with a short deadline onceagain – as if we did not have the bitter experi-ence of the past two years behind us. There isonly one quotation that should be added to theabove: “However, creating the proper size of awelfare state that is economically and sociallyacceptable is a task for which the designatedtime limit of 18 months for implementation isplainly inconceivable. The authors' approach(…) is (…) counterproductive, because theirefforts aimed at incorporating in the 18-monthtimetable questions that cannot be resolvedwithin such a short time actually representobstacles to accomplishing the very measuresthat indeed belong among the tasks of this 18-month period. “ (Szakolczai, 2006b, p. 509).The lesson of the Bokros package is also clear.While an 8 per cent import duty or crawlingpeg or – for further proof of commitment –some cutting back on certain welfare servicesof almost insignificant effect regarding thebudget can be introduced within 8 months or


742

in fact a time much shorter, in just 1-2 months,the reform of the welfare system cannot. It isincomprehensible how four noted authors inthe first instance and two in the second case –including two and one former ministers respec-tively – could put down something like that.Finally: the “situation of crisis” described inMihályi's current book (2008b, p. 21) wouldassumingly not exist, or would at least not beso severe, if the 8 and 18 months had not beenformulated as a necessity and, more important-ly, if these timeframes had not been attemptedto be implemented.

The discussion of this chapter would not becomplete, however, if basic agreements of opin-ion were not noted. While the reviewer doeshave reservations about the crisis index, onecould not more agree that stagflation is a realdanger and especially that the fall of the grossaccumulation rate from 31 to 23 per cent in justsix years is a real national catastrophe. It is thusindeed inevitable to “reverse (…) this badtrend” (p. 20).

Chapter 3 – The unchanging model: welfarestate from the cradle to the grave – would be thetheoretical basis of the book if it could really bequalified as such but one can certainly notstrive for making a theoretical basis in justeight pages. It offers two postulates, both ofwhich appear at the beginning of the bookalready and many times, repeatedly, later on.The one is that, “until today, we have failed toback out of the dead-end of socialism and ofthe centralised economy” because, while wehave successfully implemented “national free-dom, (…) the privatisation of major companiesand the permeability of borders”, the issue of“separating the two most important social wel-fare systems, pensions and health care, frompublic finances (…) has not even been raised.”(p. 9) This in fact means that the welfare sys-tem, or at least the current form of it, is a her-itage of “the dead-end of socialism, of cen-tralised economy”. (Ibid.) The other postulate

is that the Hungarian welfare state – under theterm introduced by János Kornai – is “prema-ture” (p. 10).

The first postulate, in its current form andundisputable way, is wrong. The welfare statedates back to the time of Bismarck, when therewas neither a “Great October Revolution”, nora planned economy, nor “socialism implement-ed”, and least of all was there a János Kádár.Besides, today's problems of the welfare system– the financing difficulties caused by the ageingof society and the development of medicaltechnology – are much the same in WesternEurope, where there has never been socialismlike in Eastern Europe. Thus the problem is aglobal one rather than a “post-socialist” phe-nomenon, even if there are no two countriesalike and no two welfare systems completelyalike: the German system and problem are notthe same as those of Hungary, for example. Thereviewer cannot even share Mihályi's assump-tion that there were five points that “planners(…) took as a basis” (p. 23), either. In thereviewer's opinion, what the planners took as abasis was the absolute correct realisation thatindividual and social preferences were differ-ent. If, under the Soviet conditions – and alsounder other conditions – the rate of paymentsin money had been higher and that of paymentsin kind had been lower, more money wouldhave been spent on current consumption goodsand less on education, health care and housing.To put it absolutely crudely, there would havebeen even more money spent on vodka and lesson the improvement of cultural, health care andhousing conditions, which would have hardlybeen favourable for society as a whole, let alonethe development thereof.

As regards the second postulate, “the prema-ture welfare state” as János Kornai formulatedit, discussing it here would be somewhat impo-lite. On the one hand, it is impolite to discuss aterm coined by such a distinguished author,which term is used not only nationally but


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almost all over the world, in a review on anoth-er author's article, as if in passing – but it isunavoidable to discuss it due to the series ofreferences made to it by Mihályi. On the otherhand, Kornai's relevant article was published in1992, i.e. 16 years ago, and it is impolite to callsomebody to account for something that,thank to the development of science, is widelyknown today but was not at the time.

The reviewer's first remark related to thisterm is that its formulation, its highly effectivecharacter and wittiness prompted authors touse this slogan contrary to Kornai's intentions.The term has had an independent usage, inMihályi's book and elsewhere, and has beenused to support intentions, proposals andactions – by Mihályi, too – that have not metKornai's intentions. The second remark is thatthe postulate, as has become clear by today, isimprecise; under the current stance of science,we would put the emphasis elsewhere.

Let us begin with the second remark.Kornai's original formulation in question is asfollows: “The Hungarian welfare state is »pre-mature«. According to a general observation,there is a close positive correlation between theeconomic development level and the size ofwelfare services of a country. The level of devel-opment is not the only determinative factorbut is undoubtedly one of the basic ones. Inthis respect, Hungary »ran ahead of time«.”(Kornai, 1992, p. 507) The way we would for-mulate this today would be rather that the sizeof welfare services – using the term coined byDouglass C. North – is path-dependent: itdepends on the historical traditions and earlierpolitical decisions of a country. As was alsopointed out in the elementary study book bySamuelson and Nordhaus, which I referred to inan earlier article: “the budget, the welfare stateand state redistribution, and in fact the state asa whole have inevitably a lesser role in the colo-nial states, such as the United States, and alarger role in societies where traditions have a

stronger part to play, like in ContinentalEurope.” (Szakolczai, 2006b, p. 498). Certainly,both factors have a role. Kornai also underlinesthat “the development is not the only determi-native factor but is undoubtedly one of thebasic ones”. The way we would formulate thistoday is that it is traditions and earlier politicaldecisions that are central and their effects maybe influenced by the level of development.

The above postulate is clearly supported bythe figure published on page 27 of the Mihályibook currently discussed, which lists OECDcountries according to their welfare expenditureas a percentage of GDP in the year 2003. Ifdevelopment was the factor of primary impor-tance, the United States would be on the righthand side of the figure, among the states wherethe percentage of welfare expenditure is thehighest. This is not the case, however. TheUnited States – following Korea, Mexico,Turkey and Ireland – is number five from thebottom. Other countries on the left hand sideof the figure – under the OECD average – areCanada, Australia and New-Zealand, i.e.English-speaking settler countries as well as –due to the high cultural similarity – the UnitedKingdom and Ireland. On the right hand side ofthe figure we can find the countries of conti-nental Europe, on the other hand, Scandinaviancountries being towards the right edge, withSweden right on the edge. What is more,Hungary, considering the two factors simulta-neously, is in its right place in fact: according toits continental European historical traditions, itis on the right hand side of the figure while, dueto its relatively low development level, it istowards the left compared to Italy, Austria,Germany and France. This position does in noway justify a reduction in the rate of socialexpenditure; on the contrary, it would justify acontinuous and gradual increase of the rate ofsuch expenditure in the hope of catch-uptowards the level of Germany and France. Itshould certainly be also considered that in these


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countries there are currently efforts to reducethis rate, so the target set should thus not be thecurrent level of France or Germany but a levelsomewhat lower than that.

Let us now examine the same in a historicalperspective. If it holds that social expendituredepends on the level of GDP, i.e. if higher GDPper capita involves higher social expenditure,then at around 1880, at the time of theBismarckian reforms, Germany should havebeen the richest country in Europe. Everybodyknows, however, that this was not the case.Under the figures published by AngusMaddison (2003), the actual situation was thefollowing (see Table 1).

Table 1

GDP PER CAPITA IN 12 WEST-EUROPEANCOUNTRIES IN 1880

1900 international Geary–Khamis dollars

United Kingdom 3 477

Belgium 3 065

Holland 3 046

Switzerland 2 450

Denmark 2 181

France 2 120

Austria 2 079

Germany 1 991

Sweden 1 846

Norvway 1 588

Italy 1 581

Finland 1 155

Source: Maddison (2003, pp. 60–61)

These figures need no explanation. At thetime of the introduction of the Bismarckianreforms, Germany was among the less devel-oped countries; to the reviewer surprisingly,even Austria was ahead of it in the list.Remarkably, it was the “poor, pitiable, beggar-ly” Scandinavian countries that were bottom ofthe list. Furthermore, there are no signs at allsuggesting that it was richer countries to con-struct a welfare system. On the contrary: what

can be established is rather that the introduc-tion of the welfare system was rather a means ofcatching up.

Let us now examine Kornai's actual inten-tions and recommendations, which are mostapparent from the following quotations. “Wehave heard some radical proposals aimed atdiminishing the role of the state (…) in the[welfare] sphere to a great extent, at least to thelevel characterising e.g. the United Statestoday, in short time. With the exception of anarrow band financed by the state, fast and far-reaching decentralisation and privatisationshould be implemented in both health careservices and the pension system. (…) The onlything I wish to underline in this respect is that(…) it makes a difference where we come fromand we are heading. It is one thing to decide onwhether the state should grant its citizens cer-tain rights that they have not enjoyed before,and it is another thing to decide on the with-drawal of earlier acquired rights that citizensare accustomed to. (…) The wheel of historyturns in one direction, but it cannot start turn-ing backwards. If in Great Britain there hadbeen no state-financed health care before thetime of Margaret Thatcher, her governmentwould probably not have decided for its intro-duction. But, since it had existed before Mrs.Thatcher, her government did not propose toliquidate it.” (Kornai 1992, p. 508) “Citizens ofpost-socialist societies experience much uncer-tainty that they were not familiar with before.(…) It would severely shatter many people'sfeeling of social safety if, on top of the above,state-guaranteed health services, pension provi-sion and several other welfare services col-lapsed around them. There is immense resist-ance against the fast and drastic reduction ofstate welfare services and the decentralisationand privatisation of welfare duties. What ismore, it is exactly the economic difficulties ofthe transition that put new items of expendi-ture on the agenda.” (Ibid.) Considering the


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above, it can in no way be argued that, usingthe slogan of the “premature welfare state”,Kornai wished to suggest suffocating the pre-mature newborn. It would have been fortunateif those referring to Kornai had not only takenover a single term by him that they had heardfrom a secondary or tertiary source but wouldhave taken the trouble to read what he hadactually said.

It is László Csaba (2005, 2006, 2007) whoformulated the view in accordance with “thecurrent stance of science” with reference topost socialist countries. According to his latestwork (2007) presenting the latest data and thelatest and presumably most precise conclusionsdrawn on the basis of the former, “the develop-ment of “post communist” states has takenpermanently different courses” (pp. 258–259).“The transformed countries can therefore beput into the following four categories asregards content. 1, The “rest of Visegrád” plusSlovenia. (…) 2, Baltic states plus Slovakia. (...)3, Southeast European countries, i.e. Bulgariaand Romania plus Croatia. (…) 4, Countries ofthe Community of Independent States (…).”(p. 266) “The common past does not hauntthem; it is differences that are becoming per-manent .” (p. 283). “Transformed countriesconstitute permanently different groups.Therefore, assumptions on a uniform and opti-mal way of transformation or on a more or lessarbitrary re-allocation of certain countriesfrom one group to another are both irrelevant.At the same time, the example of Romania andSlovakia prove that there is always some roomfor change.” (p. 283) Accordingly, the “debatesin many of the social sciences that have contin-ued until today, considering “what sort of cap-italism should we now choose?” lacks a materi-al basis” (p. 278), since “ the individual groupshave been formed much rather along long-termpath dependence than along the ideologies ofthe various periods and eras” (Ibid.). Mihályi'sproposal that the welfare state should be most

radically eliminated or at least diminished thuslacks a sufficient scientific foundation. InWest-Central and East-Central Europe – com-prising Germany and Austria as well as Poland,the Czech Republic, Hungary and Slovenia –the Bismarckian welfare traditions are deeprooted and are difficult to uproot throughsome radical ideological assault.

There is the case of Slovakia, on the otherhand. In this country, the radical cutback onwelfare expenditure has been successfullyimplemented – if one can speak of success inthis respect at all. There is a high price to payfor it, however. As is presented by Gyõrffy(2007b, p. 141), regarding all Central-EastEuropean countries, the rate of people whoprefer the old system to the new one from afinancial point of view is the highest inSlovakia: in 2004, it was almost 70 per cent –followed by Hungary, with over 60 per cent.This, according to Gyõrffy, (2007a, p. 196) hasthe consequence that in Slovakia – like inLithuania – “the low level of trust in the [polit-ical] regime provides considerable incentivesfor the erosion of the consensus” (Ibid.), and,consequently, “[economic political] sustain-ability can not be taken for granted” (Ibid.).Considering these consequences, this is a resultof dubious value and does not justify the cor-rectness of the radical cutback on social servic-es in the only country where the latter has beensuccessfully implemented. Besides, exactlybecause of the dissatisfaction, the governmentthat implemented the reforms has failed, sothere may arise justified doubts as regards thedurability of the reform. It is a great lesson tolearn, at the same time, that the reforms inSlovakia were implemented during two cycles,after due preparations, in a considerate way.

Chapter 4 bears the title Changing realityand is actually an introduction to Chapter 6 presenting the proposals, because of which itcan be discussed only briefly. Subchapter 4.1 hasthe title The interest alliance of employers and


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employees against the state, and discusses thefact that neither of these groups like paying taxand contributions. Subchapter 4.2, entitledWork is no obligation – and it is not worthworking anyway!, is significantly more prob-lematic. The essence of the problem is in factwhat the author described as such: “The work-force of the 5 million employees registered atthe time of the change has fallen by over 1 mil-lion” (p. 43), which means that, accordingly –as the author most precisely reveals – only3,947 thousand people of the 7,719 thousand ofemployment age, i.e. just 51.1 per cent, areactually employed. The reason why the rate ofemployment is so low is, however, not thatpeople do not want to work but that there is nowork. The situation is perfectly describedalready in the title of Subchapter 4.3 – Thehopeless situation of undereducated employ-ees: this is the sad reality.

In the rest of the subchapters, however, theauthor, following in the wake of early globaliza-tion theorists (Gyõrffy 2007a, p. 155), overesti-mates the actually existing tendencies, thereviewer believes. It is true that, as pointed outin Subchapter 4.4: “[There are] Hungariansabroad and foreigners in Hungary”, and, asSubchapter 4.5, “No work place, no work time(…)” says, the rate of atypical employment isgrowing. It also holds that, as according toSubchapter 4.6, the rate of “intangible families”,i.e. “atypical families” is similarly on the riseand finally that, as subchapter 4.7 underlines,“Everything depends on your flat”, i.e. housingproperty has wide-reaching effects. Yet, all theabove does not mean that the traditional con-ceptual system of statistics, employment andlabour affairs, taxation and the welfare systemas a whole has completely lost sense and whatwe face now is an absolutely new situation, asthe author seems to suggest. And even lessdoes it follow from the above what is describedin the beginning of Subchapter 4.8 entitledSubsidy for the sake of subsidisation?, i.e. that

this is a “squirrel's wheel of zero efficiency” (p. 65, italics in the original, Gy. Sz.).Irrespective of the above – to emphasise a basicpoint of agreement of great importance onceagain – it is true that in Hungary, just like in theUnited States before, a group of not insignifi-cant size of people living traditionally on aidhas been formed. This is indeed untenable; theaim of aiding in this case should be creatingemployment ability rather than sustaining thelack of it. This is, however, no argument againstthe system of the welfare state as a whole, asthis chapter, very well written from a publicist'spoint of view, seems to suggest.

Chapter 5 – What has become of the healthcare reform – is really what its subtitle promis-es: A subjective account (p. 73) of the events: areal novel to be read, which is difficult to bereviewed on. The reader learns first of all thatthe author has been engaged in the problem ofHungarian health care since 1997 and that for-mer minister of finance Péter Medgyessy com-missioned him to work out the health carereform (p. 73), moreover, the author has evenwritten a study book on the issue (p. 74). Itwas at the time of the 2002 parliamentary elec-tions that he became really close friends withdr. Lajos Molnár (p. 75). “When SZDSZ[Alliance of Free Democrats] was preparingfor the elections, the complete preliminaryversion of the bill on health insurance compa-nies was available to read on the party's home-page. Not a single line of it could be read onthe homepage of the Health Care Work Groupof MSZP [Hungarian Socialist Party], on theother hand. This is thus the way dr. LajosMolnár became minister of health and dr.Ágnes Horváth became his deputy.” (Ibid.) “Itis a fact that (…) the situation of Hungarianhealth care could still be considered as good inthe year 2006. (…) If (…) somebody goes tosee a doctor or gets into hospital (…), he willget the basic treatment and medication even ifhe does not give the doctors any gratuities and


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does not have a private health insurance poli-cy.” (pp. 77–78)

“In autumn 2006, minister Molnár andmyself consulted with economic experts closeto both SZDSZ and MSZP, with László Antal,Tamás Bauer, László Békesi, Lajos Bokros,István Csillag and György Surányi (…), on theopening of the health insurance market severaltimes.” (p. 89) “In spring 2007, (…) the unex-pected, voluntary resignation of Lajos Molnárleft no choice for MSZP and made the situationof SZDSZ easier in the short run. (…) It wasthus (…) that a compromise solution was madeon June 30, 2007, the last work day of thespring parliament session.” (p. 93) While thiswas probably an unexpected turn for the min-isterial apparatus, “it was even a greater surprisefor insurance companies. Insurance companieshad been working hard for the previous 12months, too. They had regularly attended theMinistry of Health for consultations, theymust have held consultations with one anotheras well, and they had probably made numerousEnglish and German-language summaries andrecords for the management of their parentcompanies. But because there were a huge proj-ect and a huge market at stake – some HUF1,000 bn annually – they did not complain at allwhen invited to the negotiating table on thehot days of July and August.” (p. 94). “The sit-uation got more and more distressing day byday, which opinion was shared by the insurancecompanies attending the negotiations as well.Therefore, in the last days of August, I request-ed the head of the insurance consortium toexpress their concerns to the top leaders of thetwo parties. The message reached its goal.Prime minister Ferenc Gyurcsány summoned ameeting of the faction leaders and experts ofthe two parties as well as of the potentialinvestors in Parliament, to be held onSeptember 13.” (p. 96) “Already in September2007, the leaders of MSZP (…) opined theyhad no chance for success with the health

insurance reform within their faction, either.From then on, all their efforts were merelyaimed at saving what could be saved and min-imising the loss of prestige for as long as sixmonths – right until the national referendumheld on March 9, 2008.” (pp. 96–97)

“Would there have been investors?” (p. 97)“In the second half of 2007, some of the insur-ance companies really lost interest. (…) Forsome of them it must have been the last strawwhen, at the end of 2007, wisemen of MSZPand experts of the Ministry of Finance raisedthe base fee of the privatisation bid to HUF 12thousand/ person. This means that everyinvestor should have paid at least this amountwhen purchasing the minority share package ofthe 22 state-established health insurance funds.Calculating with the population of 10 million,this means an investment of HUF 120 bn or,when divided up for 7–8 funds, HUF 15–17 bnper fund. This was far more than what could beconsidered as profitable under the givenboundary conditions.” (p. 98) “The decisivequestion now is which of the measures alreadytaken during the health care reform may belong-lasting and in the case of which should afast and absolute restoration of the originalstate be expected.” (p. 111)

In principle, Chapter 6 – What should bedone? – should be the central and most impor-tant chapter of the book. The Basic principlesare to be found in Subchapter 6.1. “Thechange must begin in the social security sys-tem. (…) These systems must be privatised,their financing must be separated from thestate and the direct feedback mechanismsbetween individual payment and eligibilitymust be made significantly stronger.” Everybody must be granted “portability of eli-gibility, i.e. that, in whichever country they liveand work (…), their insurance legal relationshould be continuous and guaranteed”. “The above does not mean giving up the socialsecurity principles as interpreted under EU


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norms.” “State provisions (…) are guaranteedas subjective rights (…); social aid and subsi-dies (…) are available on the basis of eligibili-ty.” The creation of employment opportuni-ties as a conceptual construction is somethingto forget. “Hungary (…) will be unable toresist (…) the temptation of one-bracket lineartaxes referred to as flat taxes.” “Social andwelfare expenditure as a whole (…) should becut back on as fast as possible.” “It isinevitable to (…) revise and/or correct thewrong decisions made in the past 10 years.” “The net migration balance (of minus 3 percent) of university graduates characteristictoday [must] be turned in the positive direc-tion.” “It is essential to present the reformof the tax and contribution system in an inte-grated package.” (pp. 115–118)

The summarised review of this nine-propos-al package can take place only at the end of theoverall review, but the reviewer wishes to pointout right away that the package is heteroge-neous, with proposals of various weight, andthat the reviewer does not support most of theproposals. The details are to be discussedbriefly as follows. Subchapter 6.2 discusses dou-ble grossing up, i.e. that nominal earnings mustinclude all contributions. Subchapter 6.3 bear-ing the title Solidarity and proportionality sup-ports the idea of “fixed amount pension contri-butions” and “fixed amount patient insurancefees” (p. 126) adding that this latter “could beimplemented only gradually” (Ibid.). The titleof Subchapter 6.4 is Making social securityfunds independent from the work place and thestate. The main conclusion of Subchapter 6.5bearing the title Transition to sector neutraltaxation is, the reviewer opines, that “in gener-al and proportional burden sharing in Hungary,progressivity is hardly implemented even inprinciple” (p. 137), which suggests that thisissue should rather not be dealt with at all.According to Subchapter 6.6 focusing on thereform of general and proportional burden

sharing, “reducing the relative significance ofincome-dependent taxation is an extremelyurgent task” (p. 140). At the same time, thissubchapter firmly supports progressive inheri-tance tax. The reason why this proposal isproblematic is, however, that it would affectdomestic capitalists only and – considering thealmost absolute lack of savings by domestichouseholds – would thus further increase for-eign ownership ratio. The same subchapterdemands the “reduction of social (welfare)expenditure” once again (p. 142). According toSubchapter 6.7 discussing the question of localtaxes and subsidies, “although the EuropeanUnion has not found any fault with it, weshould eliminate local industrial tax for ourvery own interest” (p. 143), while, at the sametime, “easing old-age poverty is something thatshould rather be dealt with largely by local gov-ernments” (p. 146), which latter is a suggestionmade without any reference to the source.Finally, according to Subchapter 6.8, “demandsof West-European level are simply not to bemet within the framework of small enterprises,at competitive prices!” (p. 149). The labourmarket subsidies designed and earlier intro-duced for small and medium enterprises haveall proven counterproductive techniques gener-ating corruption. These, too, must be cut backon”. (Ibid.) “There is no need for any amend-ments in tax or contribution regulations target-ed especially at the small and medium enter-prise sector.” (pp. 149–150)

As the closing Chapter 7, there follows theEpilogue, or where did Ferenc Gyurcsány make amistake?, which raises two questions as a way ofintroduction: “What was the opinion of theleading officials of the social-liberal coalitionheaded by Ferenc Gyurcsány on the reformproposal outlined in this book? Why havethese proposals failed to be implementedalmost completely?” (p. 151) “I definitelyknow the answer to the first question” – theauthor continues. “Neither Ferenc Gyurcsány,


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nor János Kóka had a view on the problems ofthe Hungarian economy, on what needed to bedone and on the main direction of progress dif-ferent from that of the author of this book.This can even be proven by documents. “ (p.152) At the same time, “there are three mainreasons to explain why the reform strategy ofthe prime minister-party president has failed.”(Ibid.) “He is a liberal reformer leading asocialist party.” (p. 152) “The question oforder.” (p. 153) Here the author lists the vari-ous tactical mistakes made by the prime minis-ter. “The time factor.” (p. 155)

As regards the time factor, Mihályi argues,without actually stating it, for the 18 monthsurged by the two authors (Csillag – Mihályi2006) or much rather for the 8 months urgedby the four authors (Bokros – Bauer – Csillag –Mihályi 2006), when saying the following: “In2006, the government had Parliament pass fiveimportant health care-related bills at a very fastpace. The sixth and most important bill,referred to as the fund bill, could have been eas-ily passed with the same impetus. The primeminister believed, however, that it was wiser topostpone that to a later date. He was verywrong. The delay gave an opportunity for per-sons not related to health care at all – withinthe Socialist Party and outside it – to join thedebate, organise themselves (cf. the railwaystrike) and, through the thousand channels ofsocial publicity and populist communication” –he says – “discredit the conception of govern-ment parties” (pp. 155–156) – which concep-tion, as Mihályi unmisunderstandably pointedout earlier, was not and could in no way be theconception of the Socialist Party. Mihályi thussuggested that, with a single rush, that is beforethe bigger coalition party MSZP and the publiccould have understood what was going on,everything could have been passed – and he isprobably right about this.

“Three is the Hungarian truth” – as they say– “and four is the extra on top”. Among the

three postulates of Péter Mihályi there is afourth one, since this is an independent postu-late due to its weight. This postulate is that themain reason of the slowdown was probably thehope of EU moneys – which was a vain hopethat the reviewer had warned both political andeconomic leaders and the public against, in allhis related writings. The last three paragraphsof the book – by which the author did not con-fute himself – describe a “Minimum packageuntil 2010”, i.e. another 8-months or 18-months or something similar, which begins bya “grossing up”. (p. 158)

The discussion of the book being completed,let us now start the review part. The book bearsthe title Why is the Hungarian EconomyPoorly? and the subtitle Diagnosis andTherapy. In the reviewer's opinion, the mostimportant elements of the diagnosis are cor-rect, but this diagnosis does not or does notnecessarily lead to the therapy recommendedby the author.

The right diagnosis is revealed in Chapter 4,and especially in subchapters 4.2, 4.3 and 4.7.Here the author clearly states the obvious, ashas been quoted before. Following the politicalchange, employment fell by one million; onlyjust a little more than half of the population ofemployment age are employed; the situationof undereducated employees is hopeless and –as Zsuzsa Ferge has formulated it – “there aregenerations growing up (…) in aid culture” (p.66). Why is the Hungarian economy poorly? –This is why. The diagnosis is perfect. The diag-nosis could be continued at length: much ofsociety is falling hopelessly behind – in factsuch a great part of it that it may drag alongthe whole society. Whether the part fallingbehind is one third of society, half of it or evena greater part, is subject to discussions and def-initions – it is hardly disputable, however, thatonly some one third of society, if any, is on theright path.

The wrong therapy, running through the


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whole book, is downsizing the welfare stateand cutting back on (p. 117) and reducing (p.142) social and welfare expenditure. This ther-apy, however, as the reviewer has pointed outabove, does not follow from the diagnosis butit suitable for making the patient more ill. If thediagnosis is that one million people of employ-ment age do not have a work place and are notsuitable for modern employment, either, thenthe only therapy may be to make them suitablefor employment and through this way primari-ly, as well as by other means, to ensure theiremployment. This, however, requires strength-ening the welfare state rather than diminishingit, and makes its restructuring also necessary inthe sense that its primary goal should be not tosustain the hopeless situation of people inhopeless situation, making it at least bearable,but to eliminate the hopeless situation andmake social rise possible. Restructuring thesystem is very different from diminishing it,however.

The most important element of the wrongtherapy is making a closer connection betweenindividual payment and eligibility to services,i.e. self care, although the author does not usethis phrase explicitly. The basic assumption ofthe conception is that a closer connectionbetween individual payment and eligibility, i.e.the realisation of the necessity of self careforces out self care, voluntary payment or atleast the voluntary meeting of the obligation;moreover, even saving. If deduction is trans-formed to payment, force is replaced by volun-tariness and what has been proven impossibleto force out – cf. the one thousand methods oftax and contribution avoidance – will now beimplemented voluntarily. This is an illusion,however, which does not become reality evenin the upper third of society; the foresight ofthe individual is always weaker than that of thecommunity. Twenty year olds have no way toknow if they will live to be seventy or eightybut society must know that there will be old

and ill people in fifty and sixty years' time, too.To assume fifty years' foresight and self care onthe part of the lower third of society, however,is not an illusion any more but is self deception,which no social policy can be based on.Strengthening the connection between individ-ual payment and eligibility in the lower thirdonly leads to a decrease in eligibility, and in facta major decrease, with all the tragic economic,political and social consequences involved.Thus, diminishing the welfare state, which nec-essarily deteriorates the supply of the lowerthird of society to the greatest extent, can onlymake the already hopeless situation of undered-ucated employees even more hopeless, increasethe division of society and add to trouble. It isthus unmisunderstandably true that this thera-py is contrary to the diagnosis.

The other critical element of the differencesof opinion between the author and the review-er is the reduction or increase of income, assetsand social differences. While the author aims atincreasing these by almost all of his proposals,the reviewer believes that all efforts should bemade to reduce them. Differences are clearlyincreased by reducing the welfare state and cut-ting back on welfare services, and numerousother proposals of the author from emphasis-ing the taxation of consumption to flat tax,fixed pension contributions and patient insur-ance fees all have a similar effect. In the review-er's opinion, these proposals all make the diag-nosed illness worse, fostering the fall behind ofa great part of society and the division of soci-ety as a whole, because of which they are unac-ceptable or only certain elements of them maybe acceptable after due consideration and with-in the framework of a complex programme.

So what will happen to the budget undersuch circumstances – this is a question thatPéter Mihályi could justifiably raise. Theanswer, with reference to the Swedish example,can be found in Dóra Gyõrffy's book (2007,pp. 139–172). Sweden strongly committed


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itself not simply to sustaining a cyclically cor-rected budget balance but to attaining a 2 percent surplus, i.e. to reducing the debt stocks (p.159). This target was not reached by eliminat-ing the welfare state, however, but by the com-plete transformation of the system of budgetmaking. Instead of demands, Sweden took theframework figures made possible by nationaleconomic and macroeconomic considerationsas a basis; they rejected the lawnmower princi-ple, too, and made it every minister's own task– “every minister is his own finance minister” –to make the necessary savings within their min-istries in the fields where this demanded theleast sacrifice. The result is clear: the deficit hasdisappeared – the surplus has been attained –the welfare state has been sustained.

In the reviewer's opinion – going back tothe beginning of this article – there are thusmany things we must forget:

• we must forget the various 8-month or 18-month timeframes;

• we must forget the primary importance ofdomestic policy to economic policy;

• we must forget the elimination of the wel-fare state;

• we must forget the increase of income dif-ferences; and what is most important of all,

• we must forget constructivism, i.e. theconception of forcing through solutionsconstructed at the writing desk or import-ed from elsewhere.

After discussing the serious and basic differ-ences of opinion, let us – like before – return tothe views shared. As the reviewer earlier point-ed out that it was inevitable to create a budgetbalance, it must be added here that the trans-formation of the taxation system is similarlyinevitable, the transformation of social securitysystems is inevitable just the same; moreover,even a greater reliance on self care is inevitable.Mihályi is right about all these, the revieweragrees, and several of his actual proposals arewell-grounded and worth considering. The

Swedish welfare state could be sustained notbecause it was left unchanged but because itwas transformed, and also because the order ofbudget-making was also transformed. Therecan be hardly any dispute as regards therequired direction of the transformation.Investment in human capital, i.e. expenditureon health care, education and especially furthertraining and retraining, must be sustained oreven increased – it is especially in the latterfield where an increase is justified or eveninevitable. At the same time, financial subsidiesgiven to people without employment may bereduced, and some of it may actually becomesuperfluous as a result of fruitful retraining andfurther training. Retraining and further train-ing may become an investment with fastreturn; it is widely known that there is a short-age of labour in some professions. Therefore,the financing of the welfare system is problem-atic in countries where the welfare system hasnot been transformed and the system of taxa-tion and the order of budget making have notbeen amended. It is thus not the reforms thatthe reviewer protests against: reforms areinevitable; he protests against reduction orelimination and – certainly – against unrealisti-cally short deadlines. Yet, the protest againstunrealistically short deadlines does not meanthat the reforms should be postponed. Quiteon the contrary, they must be urged, but withdue preparation and with the greatest possiblesupport of the profession and of society.

This is the point where we can return to thelast chapter of the book, the failure of FerencGyurcsány's attempt. The first element of thefailure is clear: the theoretical construction –which, Mihályi claims (cf. p. 152), was the sameas his, and this was probably the case indeed –was wrong, and a wrong construction must failsooner or later. As regards the second unit, thefollowing can be read about it in the book:“Gyurcsány (…) [was] obliged to accept alsothe reform rituals inherited from the past. One


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of these – for example – was the widely men-tioned institution of social debate, the need forwhich is talked about as much in his party as ifit was the most natural thing in the world. It isnot that at all, however. In a representationaldemocracy, all important debates, includingdebates on reforms, must be held inParliament. “Social debate” is inherited fromthe time of the single-party state and is an insti-tution contradicting the letter and spirit of theconstitution in force; in the legal sense, it is infact non-existent already.” (p. 153)

In this review, quite a number of basic dis-agreements of opinion have been revealedalready, but there is still an absolutely basic one.The reviewer des not wish to quote theConstitution, but it is widely known that theParliament is only one means of exercising

national sovereignty. More importantly even, anation is not to be governed against their will,and especially, the basic principles of the socialsystem of a nation are not to be formed againstthe nation's will. There is no political success,especially regarding basic issues, without a con-sensus – not even in a representational democra-cy. In this country, they have tried to forcesomething upon the nation that the nation didnot want to have, and it is very good that thisattempt has failed. It would have had muchworse consequences if this attempt, throughcunning efforts, had brought temporary success.

György Szakolczai*

* The author wishes to thank László Csaba and DóraGyõrffy hereby for their valuable remarks, receivedwith the usual reservations.

BOKROS, L. – BAUER, T. – CSILLAG, I. – MIHÁLYI,P. (2006): Last Chance, Élet és Irodalom, April 28,pp. 3–4

CSABA, L. (2005): The New Political Economy ofEmerging Europe, Akadémiai Publishers, Budapest

CSABA, L. (2006): The Rising Europe, AkadémiaiPublishers, Budapest

CSABA, L. (2007a): The chance of a more liveableHungary, Competitio, VI/1, June, pp. 5–18

CSABA, L. (2007b): Transition – but where? Socialdivergence in Central and Eastern Europe, In:Muraközy, pp. 258–285

CSILLAG, I. – MIHÁLYI, P. (2006): Double Bind. Theeighteen months of stabilisation and reforms, GlobalKnowledge Foundation, Budapest

CSILLAG, I. – MIHÁLYI, P. (2007): We still have a lotto learn…Public Finance Quarterly, LII/1, pp. 162–169

GYÕRFFY, D. (2007a): Democracy and Deficits.The New Political Economy of Fiscal ManagementReforms in the European Union, AkadémiaiPublishers

GYÕRFFY, D. (2007b): The heritage of the socialistsystem. The persistence and transformation of imbal-ances, In: Muraközy, pp. 131–163

KORNAI, J. (1992): Post-socialist transition andthe state: thoughts on fiscal problems, EconomicReview, XXXIX/6, June, pp. 489–512

MADDISON, A. (2003): The World Economy:Historical Statistics, OECD. Development Centre ofthe Organisation of Economic Co-operation andDevelopment, Paris

MIHÁLYI, P. (2008): Why is the HungarianEconomy Poorly? Diagnosis and Therapy, HVGBooks, Budapest

MURAKÖZY, L. (ed.) (2007): Chattering Surface –Silent Deepness. Subconsciousness of the EconomicPolicy in Hungary, Akadémiai Publishers

SZAKOLCZAI, GY. (2006a): Realistic analysis, consider-ate action wanted, Élet és irodalom, L/26, June 30, p. 14

SZAKOLCZAI, GY. (2006b): István Csillag – PéterMihályi: Double Bind. The eighteen months of stabil-isation and reforms, Public Finance Quarterly, LI/4.

SZAKOLCZAI, GY. (2007): Let's carry on learningfrom each other. Public Finance Quarterly, LII/1.

REFERENCES

BIBLIOGRAPHY REVIEW – Books

753

AThe most famous Hungarian scientist ever,John von Neumann, said the atmosphere of theEarth was the most complex thing on earth.Transposing this to economics: world economyis the most complex thing in the world. Foreconomists, a system not only more complexbut simply just bigger than the world economycannot exist – and it is this system that MihálySimai has committed himself to studying formany decades. He does not only have half adecade's past in research and education (he lec-tures on several subjects at Budapest CorvinusUniversity even today), but there is no otherHungarian economist with such wide profes-sional experience gained abroad: what is more,gained at various institutions of the most com-prehensive world organisation, the UnitedNations.

A person studying the most comprehensiveand biggest system and the operational anddevelopment rules thereof must be endowed

with various excellent qualities. Let us mentiona few of these from the two ends of the spec-trum: he must be familiar with the characteris-tics and details of the national economies thatmake up the world economy, and he must beequally well aware of the sometimes concealedwhile other times brutally overt driving forcesof international economic relations, i.e. thegeneral correlations. In the profession of eco-nomics, young researchers tend to be strong inthe former field, while mature researchers areusually experts of the latter. Mihály Simaibelongs to the latter group, not only due to hisage, but also considering his professionalachievements and the dozens of books pub-lished. Besides, there is no other economistwho has been a member of the HungarianAcademy of Sciences for longer than he has (32years) and among the eleven fellow membersthere are six world economists whom he is thedoyen of regarding his age alone. What strikes

Neither chaos, nor a world plan

Mihály Simai

The world economyin the vortex of the 21st century

AKADÉMIAI KIADÓ, BUDAPEST, 2007


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the reader in the book, i.e. that the situationdescriptions from which the conclusions aredrawn are so rich in detail and include so many(and up to date) facts, is no wonder thus. It canbe no requirement of a scientific technicalbook to be even interesting, but this latest vol-ume of Mihály Simai is indeed enjoyable toread exactly because of the great amount offacts mentioned above. The reader learns, forexample, that

• Ninety per cent of the scientists in humanhistory before the end of the twentiethcentury lived and worked in the last thirdof that century (p. 9);

• In the year 2000, 20 per cent of the popu-lation of the world received 83 per cent ofall incomes, while the poorest 20 per centreceived 1.5 per cent of all incomes (p. 33);

• In the last decade of the twentieth century,approximately 140 million people, some 2 per cent of the world population, lived ina country other than their country of birth(p. 44);

• In countries of the European Union today,the rate of women with a university degreeis 10 per cent higher than that of men (p.85). The first two chapters of the volume are a

theoretical review presenting the basic correla-tions as well as the most important fields andtendencies of change. Chapter three is devot-ed to the network of world economic relations.Chapters four and five outline the internation-alisation of the microsphere and a tangiblemanifestation thereof: the world economic roleand operational characteristics of transnationalcompanies. The sixth, closing chapter of thebook predicts the expected courses of develop-ment and it is also here where a regrettablyshort, only ten-page long evaluation ofHungary's connection to the world economywas given room in the book.

In the case of a book written by a widelyexperienced academician professor, it is not so

much the presentation of facts and tendenciesbut rather their evaluation and the answers tothe ultimate and “simple” questions that thereader (or at least the reviewer) is keen to readabout. Is the current arrangement of the worldeconomy “good” or fair? Are the institutionsof developed market economies of universalvalidity and can we expect that the spreading ofthese institutions will solve the economic prob-lems of all parts of the world? Does “the invis-ible hand” guiding development in the rightdirection exercise influence on a global scale? Isthere a need to plan development – and, if thereis, in what form and to what extent? And towhat extent would that be realistic?

Mihály Simai takes a balanced stance in theseultimate questions. He believes that, despitethe fast economic growth of the past decades,the world is not well arranged, the world econ-omy clearly “underperforms”, it is burdenedwith serious inequality and unfairness, butthere is not much hope for radical and fastchange. It is major global problems that willvery slowly force decision makers to imple-ment the right solution, and this solution willnecessarily be strengthening cooperation andcohesion.

Although there are numerous worldwide andregional institutions and integrations in opera-tion, still, ultimately: “Instead of a new worldorder, you can speak of a unique global disor-der”. (p. 18) The role of the UN, widely criti-cised and not much esteemed by many, isjudged positively by the author on the whole,while its limitations are also pointed out: theworld organisation “…has proved to be able tosurvive and operate in the world order of thetime, at the level of willingness for cooperationof the states and meeting the opportunities ofthe age “. (p. 21)

Inequality, interpreted as a difference ofincome between various countries is one of themost serious problems of the world economy,the trouble with which is not that some devel-


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op and get rich very fast but that much ofhumanity is totally left out of this develop-ment. “According to calculations by economichistorians, the difference of incomes betweenthe richest and the poorest country was 3:1 in1820. Calculated on the basis of the GDP perhead, in the year 1960, there was a thirty-timedifference already, while today, there is an overeighty-time difference between the countrieswith the highest and the lowest incomes. Abrutal manifestation of growing inequality ismass poverty.” (p. 29) Overcoming this shouldnot really be expected even in the long runsince “The analysis of data and trends revealsthat absolute poverty in the world is not a mar-ginal phenomenon that can be eased throughcharity or development aid but follows fromthe world order and the relations of the respec-tive states” (p. 35) and there is doubt if “…in aworld based on market economy primarily,there are any social interests or forces that areable to eliminate or mitigate the reasons ofpoverty” (p. 37) Sharing the view of Pope JohnPaul II, Mihály Simai quotes his encyclical let-ter creating the greatest stir, “CentesimusAnnus”, in which the pope underlined that“…although communism has collapsed, noneof the world problems that had a role in theappearance of communism have been solved”.(p. 28) Most economic problems are of socialorigin: “On our planet, there exist no physicalor technical limits that would make it impossi-ble to meet the basic needs of world populationin the foreseeable future. In a given historicalperiod, it is because of social-economic reasonsthat these needs are not met. The growing sizeof humanity and the growing poverty on Earthare not necessarily a cause and effect correla-tion.” (p. 140)

The best of all existing worlds, market econ-omy, should thus change fundamentally forworld problems to be eased in effect: “So far,capitalism has been based on several moralnorm systems: on the Darwinian, in the centre

of which is the cruel competition for survival,on Protestant norms built on diligence, sober-ness and honesty and on technocratic morality,the core of which is performance. Especiallyimportant questions are if the 'enlightened selfinterest' can prevail and under what conditionsa market system based on general human moralnorms and values like humanism, solidarity, thesupport of the weak and the downcast, therespect of public interest, the acknowledge-ment and tolerance of difference and the rejec-tion of violence can be realised?” (p. 42)

Regarding the experience of countriessuccessful in the catch-up (and equally impor-tantly because of the current situation ofHungary) it is exciting to consider what role thestate can have in the organisation of the economy.Mihály Simai finds the role of the “develop-ment state” acceptable: “The development statehas played an important role in fostering theeconomic progress of many, currently devel-oped countries. The lower the developmentlevel characteristic for the country concernedwas, the greater role the state had to beassigned. The most important tasks in this cat-egory included state industrial policy andindustry development, subventions, enterprisedevelopment and support, human resourcedevelopment, infrastructure construction andstandardisation, the facilitation of scientificand technological development, the mainte-nance of financial stability, the facilitation of industrial growth and the establishment and operation of state companies.” (p. 62)(Certainly, mainstream economics has consid-ered emphasising the above mission of the stateas “moral insanity” since the beginning of the1980's.) Despite the above, and notwithstand-ing the overweight of transnational companiesagainst governments, it is not justified to“…treat globalisation as the only and irre-versible process of global development [and] itwould be too early to eliminate states as insti-tutions”. (p. 74)


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A strong state role is an acceptable conceptonly in some countries – which constitute aminority regarding their economic strength byall means – and the implementability of theworld plan concepts of a few decades ago isremote even if it was not Jules Verne or HerbertG. Wells with a rich imagination but the laterNobel Prize awardee Jan Tinbergen, amongothers, who urged to work them out at thetime … Well, even if world plan concepts havefailed, numerous agreements and action pro-grammes have been and are to be made whichurge the treatment of global problems throughinternational cooperation. And the more seri-ous the problems are, the greater the need willbe for such programmes. (p. 93)

For the reviewer it is a reason for specialjoy that Mihály Simai has a positive attitude tothe role of NGO's in the current developmentphase of the world economy. The author says:

“In our age, civil societies reflect the subjec-tive contents of civilisations, the relationsbetween individuals and institutions.” (p. 82)What is more, “the father of classic politicaleconomics, Adam Smith, underlined in hiswork The Theory of Moral Sentiments (1759)already that, although the major driving forceof society was self interest, civil societyrestricted selfishness and helped avoid dissen-sion.” (p. 83)

It is widely known that most civil organisa-tions wishing to fill the role of the conscienceof humanity (or, to put it more modestly, ofsociety) very firmly oppose the market econo-my model pursuing economic growth. MihálySimai takes a realistic stance in this issue aswell: In the developing world, “… just likebefore, no trends wishing to restrict or reducethe consumption of material goods, either forenvironmental considerations or on a moralbasis, will be able to attain significant success.Within national frameworks, it is generallyonly »growth friendly« or »growth oriented«politicians who can expect success”. (p. 131)

Let us add, nevertheless, that one cannot reallyimagine any developed countries where theabove lines are not applicable …

It is a great plus about Mihály Simai'sbook that it is not only devoted to the tradi-tional players and mechanisms of the worldeconomy. The discussion of civil organisationshas been mentioned above, but the presentationof the various systems or “regimes”, as referredto by the author, is even more important. Themost significant of these are: “…global eco-nomic political coordination, industrial pro-duction, standardisation, agricultural produc-tion, transport and transportation (road, rail-way, sea and air), telecommunications, satel-lites, finances, relief, currencies, security offinances, accounting mechanisms, internationaltrade policy, customs affairs, raw materialturnover, tourism, sustainable development,ecological cooperation as well as globalresources of common ownership, the air, theoceans and the space. Regimes actuallyembrace all significant areas of world econom-ic relations.” (pp. 235–236) Even an outline ofthese various fields of cooperation indicatesalready that the undisturbed operation of theworld economy requires the involvement andconscious strategy of states and the establish-ment of successful “global governance”.[Explaining this widely used term with a rathervague meaning, Mihály Simai quotes the following witty definition: “…the managementof a world that nobody is responsible for”. (p. 223)]

Another argument for state involvementis the activities of transnational companies.Foreign operational capital investment is animportant source of economic growth; it is nowonder thus that governments always try topresent winning over serious investors – nomatter how high the “price” paid for them is –as their own economic diplomatic achievement.Although it is not an ignorable aspect, either,what rate of the income produced as a result of


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foreign investments remains in the recipientcountry. (We, Hungarians, do have some valu-able experience in this field already …) Thecompetition for investments – sometimes evenwithin a country – is certainly not new and ischaracteristic not only for developing coun-tries: “…in 1986-1990, companies operatingwithin the framework of the Common Marketreceived subventions worth some ECU 100 bnfor R&D and for special regional investments.In some cases, the subventions covered 70-80per cent of the investment concerned.” (p. 336,footnote)

Finally, let us return to the opinion thatthe most exciting message of a book like this isthe answers given to the ultimate questions. Thedevelopment of the world economy can beevaluated in at least two ways: the effectiverange of market economy is spreading geo-graphically, world produce is growing andworld trade is widening, while the rate of thepoor is falling. The goal of individual countriescan be no else than to find the ways and forcesthrough which they are able to increasinglysuccessfully hold out in this process. It is theseissues that growth and competitiveness theo-ries focus on. Under the other evaluation, theworld economy is burdened by increasinglyserious contradictions and things cannot verymuch longer go on the way they have untilnow. It is the latter opinion that the stance ofacademician Simai Mihály is closer to: “What isgoing on in the world now indicates that thisage is coming to its end. Changes of a huge sizeand with unforeseeable consequences are inprogress. […] In all regions of the world, aunique differentiation is under way. In this, thegrowth of inequalities and economic and socialgaps is of determinative importance. As a con-sequence of the migration pressure, the popu-lation of the world will be much more mixed.Multicultural societies are the unique meetingpoints of civilisations and may serve as a goodschool of dialogue and coexistence but may

also result in the opposition or exclusion ofcertain social groups or strata. They may equal-ly be the soil of creative diversity and ofdestructive diversity and the diversity of exclu-sion.” (p. 382)

For the former alternative to be implement-ed, firm economic political and governmentaction are required in all the countries in theworld. A prerequisite of this certainly is “…tomake decision makers better appreciate theneed for longer-term thinking and action com-mitted to the future to a greater extent, aspectsso far pushed into the background in thelabyrinth of market economy “. (p. 407) If weconsider that the manuscript of this volumewas made before the money market crisis run-ning through the world, energy prices gettingout of control once again and the rise of foodprices, we can point out with certainty that theprediction of Mihály Simai has been provenright painfully fast.

When reading the book of Mihály Simai, thereviewer was reminded of the piano play ofArthur Rubinstein: the old master, equippedwith all tricks of the trade, played with pas-sionate commitment and great humbleness tomusic. Professor Simai, too, avoids sensationalsolutions – although in the field of world eco-nomics, there would be bombastic data to pres-ent on a mass scale. His opinion and profes-sional conviction are clearly reflected in thebook; he can see the inequalities, the subordi-nate and superordinate relations prevalent inthe world economy, the disproportionate dis-tribution of the advantages of the internationalallocation of labour, the excessive role of the“paper economy” and the harmful conse-quences thereof, but he refrains from an agita-tive style (which latter is not at all alien frommany critics of the international cooperationsystem). Mihály Simai does not agitate; instead,he persuades. He has no intention to shock thereader; he rather wants to wake him up to actu-al relations and correlations. On the whole, the


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book is an excellent guide for those who needone for orientation in the vortex of the 21stcentury – and who can claim not to be needingsuch a guide?

* * *

The reviewer finds it regrettable, on theother hand, that his volume, excellent also as astudy book, was read by at least one person toofew before it went to print. It seems that thepractice characteristic at the good intellectualworkshops of several decades ago, i.e. that col-

leagues from the department discussed studybooks, no longer exists. The truth of the prin-ciple “more eyes see more” was implemented atthe time and there was less chance for misspeltnames to appear in study material meant foruniversity students like the following in this,otherwise nicely edited, volume: “Prebish”(Prebisch), “Ian Timbergen” (Jan Tinbergen),“Kautski” (Kautsky), “Bognar” (JózsefBognár!) or – something that really hurts –“Lámfalusi” (Lámfalussy).

Tamás Halm


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IIn his preface to his book László Práger startswith the thoughts he delivered in the introduc-tion to a fine art exhibition, how fittingly so,because – to a certain extent – his book is alsomade up of a series of pictures. There is nodoubt that this picture-like quality is a con-scious choice of the author. Conscious, becauseit is clearly impossible to describe within thelimits of a 300-odd page book the world econ-omy of the 21st century, the history of the 60years following World War II (or even earlierthan that) that led to globalisation or theHungarian efforts aimed at catching up andadjusting to these trends. Within the limits of abook, such events can only be flagged up, andthe interrelationship only briefly referred to.To do so, a series of pictures seems to be thebest approach. This picture-like character isalso supported by the aspiration that Práger'sbook is also intended to be a university text-book. You can rightly raise the question: how

much of this school material will the studentsremember after the examinations? The answeris: they remember a few pictures. For instance,the series of maps illustrating the developmentof European integration: in the first map(Figure 36, page 108) there are only six unifiedterritories of only six integrated countries inthe centre of Western Europe, whereas the lastmap (Figure 42, page 144) depicts 27 countrieswhose territories – with the exception ofEastern Europe – cover Europe as a whole.Práger's book -unlike other professional text-books – contains an exceptionally large numberof illustrative pictures, well-structured figuresand meaningful graphs. Moreover, the picturesare followed by picture-like language: a seem-ingly talkative surface and serious meaning;within and beyond the dividing line of integra-tion. In the concluding chapter, the authoradmits that it was about 30 years ago in thecourse of a discussion with the outstanding fig-

László Práger

Within andbeyond globaleconomy

AULA KIADÓ, BUDAPEST 2008


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ures of modern Hungarian painting that herealised: “the economy and the world beyond itare not separated, rather, they are intertwined,and efforts aimed at exploring and understand-ing them are of the same nature.”

The picture-like character of the book isvery well illustrated by the first chapter whichintroduces the reader to a global world. Ratherthan collecting thousands of different defini-tions that exist about globalisation, the authorchooses eleven mosaics of globalisation select-ing topics from a one-week news material of adaily paper. He continues the exercise by iden-tifying the clues, the key words that organisesthese mosaics in a system (global world, simul-taneous world, fibrous world and insularworld, business world). How the individualcomponents fit together is left to the reader.However, the above key words will resurfaceagain in later chapters of the book in additionto globalisation regional integration – andwhat is more – even the position of theHungarian economy can only be understoodby the use of such clues. Indeed, understand-ing them is impossible without getting toknow the development and the character ofmultinational corporations.

One other key notion, which the authorconsiders inevitable in understanding theworld today and the recent past is: competi-tion, the competition of countries, world sys-tems, regions and enterprises. “This book isabout the world. And the world is about com-petition” declares the motto at the beginningof chapter eight (page 190). The second chap-ter describes the competition of countries.First the indicators of the individual countries'fields of potentials are listed (the size of theeconomy, economic development, the size ofpopulation and territory, foreign trade, humanresources, the conditions of the environment,technological level, military force). The listclearly indicates how limited the widelyaccepted indicators, such as GDP or per capi-

ta GDP, are to describe the de facto size anddevelopment level of a given country. This isfollowed by the problem of the ranking ofcountries, an analysis illustrated by graphs andsummary tables, which explain how differentthe ranking is depending on whether the chiefindicator is per capita GDP, military spendingor the HDI indicator characterising the quali-ty of life.

The third chapter of the book deals withan economic history survey about the develop-ment of new potential fields during and afterWorld War II. This survey is closely linkedwith chapter four which describes the objec-tives, operational mechanism and the develop-ment of global international organisations thatwere established following World War II.Chapter five focuses on Europe by offering abrief summary of the history of Europeanintegration. This is a chapter with an emphasison school-text like character, a chapter whichmakes reference to an abundant source of pro-fessional literature and which describes thesubject highlighting the trends that are valideven today.

The following three chapters go beyondproviding information. They make an effort tounderstand the world around us by offering adetailed explanation about the key terms whichare only mentioned briefly in the first chapter.Chapter seven is about the world of differ-ences, he points out the globalisation by nomeans eliminates the enormous differencesbetween countries, regions and individualhuman beings. It emphasises that despite thesuccess of some countries and regions in catch-ing up, some indicators continue to showgrowing differentiation. For example, incomediscrepancies in the past twenty years increasedin the United States, in the European Unionand in Hungary as well. Deep poverty of twobillion people and the fact that some countriesare seriously losing in the world competitionremain even more serious problems.


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World competition itself is dealt with inchapter eight. In sub-chapter 8.2 the competi-tion of the countries is introduced by theauthor with the description of a few indicatorsof competitiveness and a table of countryranking based on the above. László Prágermakes no doubt about his conclusion that “anendless series of competitiveness indicatorscan produce artificial and controversial rank-ings, which provide us only with a very rela-tive picture about the real competitiveness ofthe individual countries. The following sub-chapters make it also clear that world compe-tition is not limited to a competition betweencountries, it is a clash of different cultures:the cold war between the capitalist and social-ist world orders, the tension between theAmerican and European approaches, the com-petition between a liberal and a welfare statemodel. By know it has become evident thatthis competition has produced a number oflosers (the socialist world order has failed, andthe so-called Washington consensus, whichreflected the basic principles of a liberal eco-nomic policy, has proved to be incapable ofputting the developing and former socialistcountries on a harmonious developmentpath). The competition also has its winners(China, India, and some European countrieswhich have been able to benefit from accedingto the European Union). Russia also seems tobe an increasingly dominant player in theworld competition.

The presentation of globalisation, the worldcompetition is not a purpose in itself, rather, itserves the purpose of highlighting the oppor-tunities and challenges facing the Hungarianeconomy and society. The external environ-ment is going to be only one defining factor ofHungary's future development, its past devel-opment also plays an important role as to howthe country can step forward. Here is a quota-tion from the author: “Today, in early 2008,rather than dealing with current, momentary

actual questions, I regard it more important tostudy the path we have so far taken, to reviewour track record and to analyse how the pasttrends and the different forces behind thesetrends have become incorporated into theHungarian economic, political and powerstructures. The history of socialism inHungary is also briefly dealt with by theauthor, who concentrates on the possible waysout, recognising the fact that for the universi-ty students of today the story belongs to thepages of history. There is also a consciouseffort made by the author to indicate that thisis not “old history”, but it is a page of historythat still has its impact on today, for example,the author illustrates the event the 1956 revo-lution by quoting from his own diary. A simi-lar illustration is a recollection of the good olddictation exercise from his school days, whichused to serve the purpose of ideological educa-tion. This personal touch is present in thebook in a number of different chapters, forinstance, the author shares his experience offoreign study trips with the readers illustratingthem with letters he received and picturestaken about him. This practice may be some-what unusual in Hungary, but it is certainlynot a purpose in itself but to illustrate thatbooks are not enough to understand the worldaround us. We also need the filter of our ownexperiences, an exercise in which we acceptthat its subjectivity may be understood or maybe misunderstood.

Chapter ten finally comes to describe theevents of the recent past demonstrating thatthe system change in Hungary was, in fact, pre-ceded by a change in the external arena offorces, by domestic economic reforms and bypolitical erosion.

The last but one chapter has a surprisingtitle: global Hungary in a global world. Howcan a country be called global? The answer isactually given by the author a few chapters ear-lier, when chapter six on transnational corpora-


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tions and on the world on financial capitalbegins with the following quotation: “We areliving in a global world, and the global world isliving within – this is probably the most gener-al definition in the 21st century of the correla-tions characterising the economy, the worldbeyond the economy and the various field ofpotentials”. I must admit that when the authorwrites about “within”, I interpret this word as aterm referring to within us, people, whoselifestyle and consumption are significantlyinfluenced by the supply of international enter-prises, people, whose aspirations and desiresare also closely associated with the opportuni-ties offered by a global world or, alternatively,associated with the rejection of it. In chapter11, the author himself spells out that the world“within” also means Hungary, as we are clearlywitnessing the impact of the global world onthe structure of the Hungarian economy. Thisnotion is presented by the author by describingthe changes in the export-import structure ofthis county, by presenting how foreign capitalis gaining ground, how corporate structures arebeing transformed and by illustrating the seri-ous difficulties caused by unemployment.Hungary has not just accidentally drifted intothis international arena, rather, it has deliber-ately adjusted to it. This chapter, and to a cer-tain aspect, previous chapters as well presentthis process in a detailed way, they describe thedevelopment as a result of which this countryhas become a ,member of every significantinternational organisation and, as a result of aprolonged multi-staged process, acceded to theEuropean Union. The author, however, alsomake it quite clear – illustrating the subjectwith a number of statistical data- that whileHungary was adjusting itself to the actualworld economic area, each and ever Hungariangovernment seems to have been deluded bymany illusions and repeatedly failed to stand upstrongly and firmly for the upholding ofHungarian interests.

Having presented the global forces andthe crooked curves of the road Hungary hastaken, in the final chapter, the author venturesto draw attention to some of the major chal-lenges facing this country. The title of chaptertwelve is quite telling: within and beyond theeconomy (about balances and potential waysout). This is the chapter that emphasises whatother factors – in addition to economic factors– are likely to play an important role in thefuture development of Hungary. Indeed, at thevery beginning of this chapter the authorpoints out: “among the possible opportunitiesthat offer a way out, the Hungarian peoplethemselves have a defining role to play: thepopulation number, the health condition, levelof culture, schooling, activity, set of values andtheir cohesion. Or if these components areabsent, the power to create them” (page 318).For the readers it is clear: this is what theauthor is hoping for, since he is enumerating along list of data to prove that the above factorsare the ones in which Hungary is faced withcompetitiveness weaknesses, in other words,the improving quantitative indicators (thenumber of high school graduates, universitystudents) was not coupled with qualitativeimprovement. The conclusion: if we are awareof our weaknesses, then by systematically elim-inating them, we will be able to improve ourcompetitiveness in the world.

It is easy to discover most of these weak-nesses within the economy. A thorough analy-sis is given by the author on the gap betweenlarge and small enterprises, a gap “which isextraordinarily wide in international – includ-ing European – comparison (page 324). Theauthor also points out that the proportions offoreign-Hungarian ownership, vis-a-vis theproportion of large and small enterprises andthe taxation of labour and capital are stronglyinterrelated. Later on, the author stresses thatHungary badly needs foreign capital invest-ment, however, foreign capital contributes to


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the widening regional gaps and also to growingdisparities among enterprises in the Hungarianeconomy. EU funds may be mobilised to miti-gate such differences and further efforts areneeded to boost the domestic sector of SMEsand to assist regions that are lagging behind. Itis also important to coordinate corporateinvestments with state development projectson local, regional and state levels. This is thecontext in which at the end of his book the

author formulates one of the most importantrues of the 21st century which offers a hopeand a chance as well: “In the world of todaythere is no separate local or regional balance.No transnational corporation and, as a matterof fact, no country can have an isolated devel-opment path or balanced position isolatedfrom the external environment and from theinternal conditions” (page 328).

Gyula Pulay

BIBILIOGRAPHY REVIEW – Books

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TThere has been a rising popularity to studynon-Keynesian effects and that of the fiscalmultiplier to be negative (fiscal cuts are fol-lowed by output growth). For readers on thisEast-Central European part of the world thisbook is sailing on some un-chartered waterswhen providing some clues and a vast array ofempirical evidence for the fiscal consolidationexperience of the recent past of leadingOECD and EU countries. The aim is clear:helping to solve the puzzle when and underwhat conditions can fiscal consolidation leadto accelerated growth even in the short run.The ultimate goal of the book is to contributeto our understanding why only a few coun-tries have experienced short term non-Keynesian effects while others, not at all. Thisremarkable effort to enrich our understandingof unusual fiscal phenomenon has been almostentirely successful, it did deliver on its prom-ise. The study of István Benczes is a concise,

well-structured scholarly work that offersrich, albeit careful analysis with balancedviews on the diverse literature. The mono-graph pays special attention to criticallyassessing the underlying theories and marshalssolid evidence on the growing relevance ofnon-Keynesian effects in markets both Eastand West. The work sheds new light, longsought after, on why there has been onlyslight progress made and on why repeated fail-ures characterized the Hungarian fiscal scene.

Part I, – as can be expected from a genuinescholarly piece – guides us through the relevantbranches of the literature that identify andexplain the exceptional fiscal episode. Theintroduction offers a clear structure to be fol-lowed and a reasonable explanation why a com-parative political economy perspective waschosen. In chapter 2, the study goes on to sur-vey and critically assess some major fiscalepisodes from the EU countries' experience. It

Weathering the storm

István Benczes

Trimming the sailsThe comparative political economyof expansionary fiscal ConsolidationsA Hungarian perspective

CEU PRESS, BUDAPEST–NEW YORK, 2008


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convincingly demonstrates that not all fiscalconsolidations resulted in improved publicfinances (when improvement is measured bylower debt/GDP ratios). In fact, – proceedsBenczes to argue – it was rare to have lastingdebt reductions (p. 29). It is argued with thor-ough elaboration, and it gets firmly proven thatnot all fiscal consolidations had lead to outputacceleration. Conditions and adjustment pathsvary as a function of many variables. Asopposed to common belief, one can learn thatthe size of the adjustment itself is not a goodpredictor of either persistence, or when andwhether expansionary effects are likely to comeat all. Many caveats apply though. If that is notenough uncertainty, methodological complica-tions also abound in trying to predict accelera-tion. However, the problems with the predict-ing power of models cannot hide the fact thatinternational comparative studies have allfound some evidence on non-Keynesian effectsin the OECD countries.

Next, in chapter 3, the arguments of theso called expectational view (with the nonlin-ear approach) of fiscal consolidation are sur-veyed and put to an interesting discussion.The author duly emphasizes that a very care-ful identification is needed to understand like-ly changes in individuals' expectations. Thesize of fiscal adjustment itself, the going levelsof the acceleration of the debt ratios, and thestructure of government spending were sin-gled out as the main factors which triggerchanges in expectations to alter currentspending and the discounting of future tax lia-bilities. The deep scrutiny of modern con-sumption theory has underlined the impor-tance of the expectational view as well as thatof the liquidity constraint. Benczes claims –very reasonably – that the relevance of the liq-uidity constraint is still bothering, it does notsupport the automatic appearance of non -Keynesian effects. A key message of thischapter – and, I hasten to add, it may also be

considered as key finding of the entire study,– is that the due relevance of the financialdeepening still remains. In countries with rel-atively underdeveloped financial systems andbanking traditions, (e.g. Hungary, as we shallread later in the book) this fact gains an evenfurther leveraged importance.

Chapter 4 should be looked at as the richtreasury of most valuable track records accu-mulated by the developed labor markets,where critical adjustments took place: refer-ence is made to the EU 14, and to some otherspecific country experiences throughout the1980s and 1990s, Ireland (1987–1989),Denmark (1983–1984) UK, (1997–1998).These adjustment experiences, although differ-ent in composition, speed, and underlyingstructure, have all pointed to the same direc-tion. Namely, pretty much in line with the sup-ply side literature, they claim that there shouldbe no sacred cows in the items destined to becut. Benczes argues that even the cutbacks inpolitically sensitive items may give additionalsupport to the crowding in effects for firmswishing to invest more, due to their enhancedcompetitiveness. Within a simple statisticalanalysis of the sample countries, this chapterhas shown that it is not just the size of theadjustment alone, but the composition alsomatters in debt reduction to help non-Keynesian effects to take off. As cited by theauthor himself, the more than decade-old ideaof Alesina–Perotti (1995: 240) is still alive andkicking:

“There is bad news and good news in theseresults. The bad news is that one cannot avoidcutting transfers and government employment;quite simply, permanently favorable results typi-cally do not follow from politically palatable poli-cies. The good news is that major fiscal adjust-ments do not cause major recessions. Politiciansand their advisers must stop thinking of just abouteverything on the expenditure side of governmentbudgets as untouchable” (cited by B. I. p. 102)


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One can be in full agreement with theauthor's major argument in this regard when hestates: In modern democracies the basic ques-tion does remain: “how can fiscal consolidationbased on welfare cuts and government wage billreduction be implemented in a highly rigid labormarket?” (p. 103). Indeed this is the toughassignment for all serious thinkers. This dilem-ma probably points much further beyond thanknown frameworks of pure macro-economics,it carries us to the realm of political economy.The author is more than aware of that and usesthis awareness to the benefit of his own argu-ment. Benczes' analysis of the very concreteconsolidation cases, mainly regarded as successstories of the Netherlands, Ireland and the UK,leaves no doubt in my mind about his com-mendable convictions that fiscal consolidationbased on expenditure cuts has a better chanceof success (even with non-Keynesian effects)than revenue based adjustments. This convic-tion of his, however, has been, after a rigorousanalysis, converted into a well founded conclu-sion. Neither the conviction nor the conclu-sion, of course, are enough, admits the authorhimself, without a minimum level of social con-sensus. The latter is the most indispensable fac-tor of success and is, at the same time, the mostdifficult to arrive at. I gather, recipes for sucharrivals vary more than do fiscal consolidationadjustment paths. With all that in mind,Benczes honestly claims that “it would be anexaggeration to state that we have found andverified a causal relationship between fiscaladjustment and growth acceleration.” The dif-ferent views as well as the supply – anddemand side interpretations are naturally notmutually exclusive as Rzonca and Cizkowicz(2005: 9) put it : “the different views are notcompeting, but complementary”. This balancedview is most probably fool-proof, but will thisscientifically sound observation get anybodycloser to policy action ? Well, as always, that isnot up to science to tell. Nonetheless, a little

more decisive stand here would have beenmore appreciated.

Part two of the book takes us closer tosome harsher realities, to those of theHungarian fiscal scene, which in the last 15years has been repeatedly labeled as deeplytroubled. In this second part of the volumeone gets a fair display of how sound principlesand fine consolidation concepts work in thereal world of government books andmachineries. They tend to perform poorly.Adding, of course, that when investigating, allapplication of principles is assumed to be putin place as prescribed. When confrontingactual Hungarian practices some surprise doawait us. The broad comparative perspectivewhich is offered in this chapter for the testingthe institutional conditions of non-Keynesianeffects in Hungary, come as no surprise. Muchrather, some of its findings: the very inflexi-ble, remnants of ancient socialistic labor mar-ket conditions that still prevail prompt thereader for a head scratch. One otherwise getsthe largely expected results of a properlystructured, disciplined survey on matters suchas the role of financial intermediation, a good,detailed structural analysis of the expenditureside, and the inevitable, market-principle-driven, yet down-to -earth discussion of theHungarian labor scene.

Chapter 5 has clearly reestablished thatthe Hungarian financial market (banking sec-tor) is by now developed enough – as con-firmed by Szapáry (2002: 115) – to facilitatethe emergence of expansionary effects byeliminating the credit constraint. Indeed, overthe last 6 years, consumer loans have grown atdouble digit rates, and at present make up animportant component of banks assets. Thesetypes of lending are rapidly closing the for-merly existing gap with company loans. It gota marked indication in this section of thebook that the euro adoption will most likelyextensify credit growth. This is a very valid


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point worth the attention of policy makers.The exposure of most Hungarian banks' con-sumer loan portfolio is large to foreignexchange risk, since CHF, Euro, and yen-denominated assets have been increasing at anunexpectedly high rate. Easy access to credithas had radical changes to occur to alter bor-rowing preferences. In Hungary, there hasbeen probably much quicker reactions andmore responsiveness to changes in availablecredit facilities than earlier thought by any-body in the financial sector. Between 2000 and2004, financial firms mostly car leasing andpurchase were able to double their share in themarket and stabilized since then. True, theforeign exchange risk exposure involved is notseen, or is not properly understood by manyparticipants. However, from the point of viewof financial intermediation the global creditchannel have for sure helped the spread ofnon-Keynesian effects. Along with the grow-ing availability of foreign funds, the fiscal dis-cipline has definitely worsened as there wasless competition for domestic savings. As anegative consequence, global sources of fund-ing removed a domestic savings constraint onbudgetary overspending. At the end of this5th chapter, it is rightly pointed out that theopen economy environment brings furthercomplications for the adjustment since therewas deterioration of both internal and exter-nal equilibrium. To use Benczes' term, the“vicious circle” of budgetary overspending didnot seem to disappear. On the contrary, itseemed that the ease of borrowing foreignfunds did not help the cause of macroeco-nomic adjustment at all.

Chapter 6 gives a decompositional analy-sis of the expenditure side of the Hungariangeneral government. It covers a wide range ofissues and analytical aspects. The main thrustof the argument is that the public indebted-ness is well above the justified level. In addi-tion, the redistribution rate, in GDP terms, is

about 50%, some 10 percentage points higherthan the CEE-8 average. However, it equallyexceeds the EU-15 average, reaching levels ofcountries who have twice the per capitaincome of Hungary. These are more than visi-ble disproportions that cry for change. TheHungarian case is the sad saga of stubborn fis-cal deficits giving us the worst spots in EUpublic finance rankings. Benczes admits thatthe composition of the budget does not offerany space for much pride either. The main-tained levels of state employment reflect aheavy dose of over-employment (in 2006,some staggering 25% were on state pay roll).Disability, sick leave pay, early-retirementbenefit related payoffs are also way too gener-ous, which are all representing strong disin-centives to work. What is more, subsidies ondrugs and housing are also heavy-weight itemsfor current expenditures. For Hungary, thesustainable level of debt to GDP, according toBenczes, is about 40% (which appears reason-able, though the number does not get any fur-ther reference or calculus-driven support).True, the officially registered debt levels havebeen (and are currently) way above that, hit-ting the lower 60s. The sad indebtedness pic-ture does get any rosier by the fact that for-eigners are holding ever larger shares. Overthe last three years, foreign holdings have runup above 25% of total public debt outstand-ing. The price of borrowing (with climbingrisk premium) has gone up steep north, seri-ously hurting the fiscal balance. We are sorryto report that in the last two years, (for whichthe study could account), in this regard, thereis no change on site. So, the warnings ofBenczes are warranted, on target, and are astimely as ever.

The descriptions and analytic commentsmade in the next chapter on the rather slowdevelopments of the Hungarian labor mar-ket, which have long left its working soldiersin the woods of socialistic traditions, are all


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in good fit with the main line of the argu-ments for the slow start of expansionaryeffects. Theoretically, flexible labor marketscan enhance expansionary effects, if govern-ment is willing to go ahead with cuts on wel-fare items and on wage bills. One gets theimpression from this 7th chapter also thattheory is fine on paper in Hungary, too. Yet,because of a complete lack of social consen-sus on what government should or may do,vital encompassing social agreements are noton the horizon. Governments past and pres-ent could only weather the storms of fiscalconsolidations but they never successfullynavigated out of the storm zone. Way morethan nothing that many of them managed todo, but all of them have lost direction andgained no or very little mileage. There wereonly look-warm efforts – and with that adjec-tive we are forgiving – to pull social partnerstogether and more importantly, to have theirpolitical representatives, sitting in on bothsides of the isle, arrive on a social minimum.The crucial effort to reach that minimum isslipping away repeatedly. As a last dramaticepisode of that unmoving story, an ill-defined, knowingly budget-elated referen-dum in March 2008 just put an end to suchefforts for quite a while.

It has been richly documented and convinc-ingly argued throughout the book that demandand supply side non-Keynesian effects alike arehighly sensitive to institutional settings. In thepresence of liquidity constraint their strongimpact would be most doubtful. What is more,many lead to disillusionment, and worse, toreversals. To avoid all these bad outcomes poli-cy makers have to go through a long check listof necessary conditions to be aligned withwhen they wish to take their consolidationefforts to success. (Table 8.1 /p. 219/offers thatlist for easy and rapid reference). When it cometo assessing the Hungarian relevance of non-Keynesian effects Benczes stays pragmatic in

drawing relevant conclusion from the vast arrayof possible theoretical outcomes. He firmlyconcludes that the consolidation road followedin 1995-96 with deep currency depreciation anda loosening of monetary policy is not open anymore. This view is fully supported by LászlóCsaba (2005:201)

The GSP with its strict Maastricht criterialeaves the door open for fiscal measure only.With an increased credibility along with aspeeding up of euro adoption there can behope that financial intermediation will furtherhelp the convergence progress. On matterssuch as what Hungary can or may learn oradopt from the rich EU experience I do notshare the author's skepticism. In my view,there are ample opportunities to adopt goodpractices from the more mature EU membersto increase social cohesion and consensusbuilding. It is also a matter of wills and serious(honest) efforts. Despite the fact thatHungarian social partners are fragmented andoften hostile to each other, the lack of collec-tive action of the dominant player may beovercome.

FINALLY, the overall assessment of and pre-diction of Benczes on Hungary's special caseis straightforward: In Hungary, it is stillunlikely that the fiscal multiplier could turnout to be negative and provide acceleration.Despite that unfavorable forecast, Hungaryhas to go forward with its far-reaching fiscalconsolidation, otherwise international marketforces will force the country to adjust. Thelatter will be, without the slightest doubt,more painful (I allow, occasionally even bru-tal) and more costly to everyone. One canpromptly agree, no further discussion is need-ed on that score.

To summarize, this book is a very good andtimely piece of a young scholar, who is armedwith all the modern artillery of contemporarymacroeconomics. His work gave many newinsights into the options to remedy the


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plagued Hungarian fiscal scene. Especiallyvaluable are his contributions to the issues offinancial intermediation, which to quote thewords of György Szapáry, former viseGovernor for the Hungarian National Bank: “Amost welcome novelty of his work is the investi-gation of the role of non-Keynesian effects”. The

book is eminently suited for classroom use andas reference volume. It could only be wishedthat some super diligent members of parlia-ment devote their precious time to this volumeas bed side reading.

István Magas

ALESINA, ALBERTO and ROBERTO PEROTTI (1995):Fiscal expansion and adjustment in OECD countries,Economic Policy, 10: 21 October, pp. 207–248

CSABA, L. (2005) The New Political Economy ofEmerging Europe, Akadémiai Kiadó, Budapest

RZONCA, A. and CIZKOWICZ, P. (2005): Non-Keynesian effects of fiscal contraction in new member

states, European Central Bank Working Paper Series,no. 519. September

SZAPÁRY, GY. (2002) Banking reform in Hungary?What we have learned and what are the prospects?Comparative Economic Studies, 44: 2, 3 Summer-Fall,pp.103–124

LITERATURE

BIBLIOGAPH REVIEW – Books

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IIf you open the textbook titled Financial (sys-tem) theory by András Vigvári you have quite afew points of departure to review it. One suchstarting point is to state that the world referredto as financial system is described by the authorwith unique thoroughness. Another possibleapproach is to begin with the pedagogical anddidactic viewpoints which are equally impor-tant, since Financial (system) theory is intend-ed to be a textbook, an objective which is clear-ly served by the conscious way the text is han-dled by the author and the way the book isdivided into different layers reflecting a pro-nounced structure of content.

In a critical review it is also justifiable tohighlight the significance of the theoretical andphilosophical components which also play adominant role in this work. Developing theo-ries has always been the fundamental objectiveand aspiration of each and every scientific dis-cipline, since this is the only way to compre-

hend and explain the operation of the studiedsubject. When you are learning about the his-tory of economic theories you are actually test-ing their application, because the relationshipof economics with its own history (i.e. with thehistory of economic theories) is fundamentallydefined by its particular characteristic features.Researchers of natural sciences attach far lessimportance to the various ways their predeces-sors made discoveries that in those historicmoments represented the boundaries of a givendiscipline, boundaries which were furtherstretched by every new scientific accomplish-ment. The logic used by economists is differentfrom the usual road followed by natural scien-tists, as economists are involved in studying aconstantly changing world, which is too com-plex to study without a certain selection of thephenomena under review. Economists searchfor general trends behind events that do notoccur with a repeated pattern, trends that may

What is the relevance of a general system theory?

András Vigvári

Financial systemA non-mainstream approach

AKADÉMIAI KIADÓ, BUDAPEST, 2008


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create a proper ground for scientific observa-tion, in other words, the simplification of thestudied events enables researchers to find theconstant and repeated elements in this seem-ingly disorderly chaos. This is exactly the verydomain in which economic theories offer use-ful assistance by providing economists with thetools of analysis. It is economic theories thathelp us concentrate on the relevant factors,events and processes only. For the above rea-son, we cannot say that there is only one rele-vant theory in economic science, as quite dif-ferent theories are applied to describe differentphenomena as analytical tools. It is finally up toeach economist to decide the adequate frame-work to be applied. From this point of view,Financial (system) theory fully complies withthe tradition which goes back to the 19th cen-tury and which is still alive (and quite useful),i.e. the tradition of a historical introduction,the summary of methodological principles orthe presentation of the greatest figures of thisscientific discipline, a traditional introductionthat serves to appreciate the results of econom-ics. In this school material colourful stories andbrief portraits of outstanding economists areused by the author to make this book an easyreading by mixing serious scientific text withreading material which satisfies the curiosity ofthe readers. Each and every layer of the textreflects thorough editorial work, because thepresentation of the subject is indeed concen-trated on the essential points without neglect-ing the fundamental intention to convey scien-tific knowledge to the readers. Although fre-quent references are made to theoretical prob-lems, their presentation is not lost in describingthe details of high theory. It is up to the read-ers to decide how much they want to extendtheir studies in such details. The highlightingof relevant scientific problems and the abun-dance of scientific references will help the read-ers to do further research. In addition to all theabove merits, mention must be made of the

main intellectual message of the book, i.e. theapproach of the author which treats the finan-cial system as a system.

Let us see what is the concept of generalsystem theory. According to the concept ofHusserl (1936), who advocated the crisis ofsciences, a scientific discipline is deemed to bein a crisis if its scholarly character becomesquestionable, in other words, the way itsobjectives are defined and its methods aredeveloped to reach its objectives. Sciencesapproach reality in a scholarly manner, but thisis not necessarily the only and not even thebest method of grappling reality. The crisis ofsciences was actually caused by a one-sidedtheoretical approach which led to a loss oftheir relevance vis-a-vis the problems of reallife. In the middle of the 20th century, atten-tion was focused on another aspect of the cri-sis of sciences, when detrimental side-effectsof scientific specialisation were pointed out. Itbecame increasingly evident that representa-tives of the individual branches of sciencecould no longer communicate with each other.Scientific dialogue was limited to physiciststalking to physicists only, economists talkingto economists only. The lack of communica-tion between disciplines was clearly due to theabsence of a common language. The accumu-lation of knowledge is by acquiring meaning-ful information, as a result of which the struc-ture and content of previous knowledge arebeing reorganised. The chances of this reor-ganisation of knowledge are reduced by spe-cialisation and, as a result, the development ofscience slows down, and the representatives ofa given science are becoming increasinglyincapable of receiving knowledge from otherdisciplines.

General system theory offered a possiblesolution for the above crisis of sciences by cre-ating a framework, which can restore commu-nication among the individual subcultures ofscience. General system theory never wanted


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to become a general theory. It does not aspire todescribe reality by condensing it into one sin-gle comprehensive theory or by trying to gobeyond the particular theories of the individualbranches of science. Instead, change was pri-marily brought by the appearance of hybrid sci-ence (physical chemistry, biophysics, biochem-istry, astrophysics, social psychology, econom-ic psychology or economic sociology). Generalsystem theory, however, represents a uniformview and a specific structure which makes theempiric universe accessible for each and everybranch of science. By using general system the-ory, the various phenomena (especially theones that are studied by different disciplines)that were formerly described only by the indi-vidual disciplines can now be integrated intogeneral frameworks or general theoreticalmodels that can be handled by each branch ofscience without losing the relevant descriptionof these phenomena. (For example, the modelsof population growth and interactions, whichare equally significant in describing ecologicalsystems or capital theories. Such models basi-cally describe the very same processes by usingthe very same definitions, each and everymodel represents the competitive, complemen-tary or parasite-type relationship of the indi-vidual species' population, and these individualspecies can actually mean individuals, products,social classes or even molecules). In conclu-sion, this is about unifying the methodology ofthe individual branches of science (or at least itis about an effort to do so). System theory canbe interpreted as a frame, which may presentitself as a permanent medium for the constantchanges of the individual branches of science.(According to some schools of thought, sys-tem theory failed to meet expectations because– as it is claimed – neither general system theoryitself nor a system-based approach can bedefined as something outside the domain ofscientific disciplines, in other words, systemtheory has also become specialised).

András Vigvári observes the structure andoperation of modern societies as a complex setof phenomena which represents only one layerof this building block of economy, also a com-plex system in itself. The financial system isonly a segment, a sub-system of the above. Sincewe are faced with an immeasurably large num-ber of phenomena, components and players, soit is considerably easier to identify the playersand to understand the operation of the systemif we observe this world with a systemapproach. General system theory is used by theauthor as a tool to apply this way of observa-tion. However, the author goes even beyondthat. System theory is not only a very helpfulmeans of understanding the operation of thefinancial system, but by using it, the interac-tions between the financial system and its envi-ronment also become visible and describable.The presentation of the interaction betweenthe financial system and its environment, i.e.the economic and social system, is especiallyimportant, because each and every segment ofthe economy is intertwined by money, whichactually defines their development. The finan-cial system itself has also been developing in away its environment has demanded or made itpossible. This is the condition which makes itpossible for the author to treat the monetarysystem, the financial system and the fiscal sys-tem in a complementary way. The questionsdealing with the interaction between the finan-cial system and its social environment are mostvisible in the chapter dealing with a compre-hensive overview of the operation of the fiscalsystem. In the second part of the book, thisperspective becomes even broader and thefinancial system is dealt with in the context ofopen economies. Starting with the basic con-cepts, such as exchanges rate convertibility, bal-ance of payment, the readers can venture intothe exciting arena of the world economy andthey can study its operation from this particu-lar viewpoint. In the meantime, system theory


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continues to be the major means of analysis, inother words, while discussing the internationalfinancial system, its components, processesand its structure are consciously separatedfrom their environment, while the system itselfis presented as a total entity made up of theabove building blocks. In conclusion, Financial(system) theory does its best to prepare thereaders to navigate in the financial world andprovides them with an effective method of eco-nomic thinking and analysis.

Finally, a few words about those the bookintends to appeal to. We can only agree withthe author's recommendation saying that thebook intends to appeal not only to the univer-sity students of economic sciences, who are the

obvious and primary clients of this book. Sincethe related branches of knowledge, such associology, increasingly venture into territorieswhich have traditionally been linked to eco-nomics (for example, the economic or budget-ary policy aspects of regional and local devel-opment), students, teachers and practicalexperts of such related branches of knowledgewill also find this book useful. The author's rec-ommendations again bring us back to systemapproach, because those who are interested inthe research methodology of social sciencescan also acquire new knowledge by reading thisbook in which general system theory is consis-tently applied.

Péter Galbács

LITERATURE

BOULDING, K. E. (1956): General Systems Theory– The Skeleton of Science, In: Management Science,April, pp. 197–208

HUSSERL, E. (1998): Crisis of European sciencesI–II, Budapest, Atlantisz

LANGLOIS, R. N. (1983): Systems Theory,Knowledge, and the Social Sciences, In: Machlup, F. –Mansfield, U. (eds.) (1983): The Study of Information– Interdisciplinary Messages, New York, John Wiley,pp. 581–600

ULLMENN, T. (2007): Edmund Husserl, Budapest,Hungarian Phenomenological Society (MagyarFenomenológiai Egyesület)

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