The Hungarian government has recently introduced several changes to the country’s tax system. But are they part of a well thought-out comprehensive reform, or are they just a collection of ad hoc measures inspired by sudden ideas?
The Hungarian government has a clear plan to systematically create a new tax system, which will be competitive even in a regional context in the medium term, PwC tax partner Tamás Lőcsei told the Budapest Business Journal. The new system aims to enhance Hungary’s competitiveness and reduce redistribution. “I believe that if the international environment is favorable, this tax system will be able to give a boost to the economy,” he noted.
Compared to countries at a similar stage of development, the average tax burden relative to GDP was remarkably high in Hungary, at approximately 40%, exceeding the average of the EU-27 or the eurozone, according to the National Economy Ministry. Due to the cut in corporate taxes implemented in July 2010, the tax bite dropped to 37.6%. As a result of the introduction of the flat-rate personal income tax in January 2011, tax liabilities are expected to decrease to 36.5%, the ministry said.
Easing the administrative burden of Hungarian companies is a long-awaited development, Lőcsei stressed. “We have been asking for that for ages,” he added. The lower tax rate will have a positive effect on the economy, especially if the extra income is reinvested by enterprises, said Zoltán Lambert, managing partner of accounting firm HLB Klient. “On the downside, I have doubts about its success in whitening the economy,” he noted. The expert does not see a change in taxpayer behavior – declaring only a part of their income – happening without tighter control.
High price for lower rate
The introduction of the flat-rate personal income tax will cost the economy several billion forints, Lambert pointed out. By favoring higher earners, the government is probably aiming to support those who will reinvest rather than spend the extra income. This way, it could support certain sectors, such as construction, he added. Although the new tax is more transparent than the previous one, social security contributions still account for significant deductions from wages, Lambert said. All employees care about is their net income, he added. The new tax rate coupled with the New Széchenyi Plan could give a boost to economic growth, according to Lambert. On the other hand, it is a highly sensitive social issue, which has provoked heated reactions.
The personal income tax rate in Romania and Slovakia, Hungary’s main competitors, is a respective 16% and 19%, Lőcsei pointed out. Austria does not have a flat rate, but when a country is developed enough to have a strong middle class and there are less poor people, then it needs an entirely different tax system. This is not the case yet in Hungary, he added.
Corporate tax rate favors SMEs
The government is favoring SMEs with the new corporate tax rate, Lambert said. He pointed out that while the 10% tax rate is applicable to most companies, the majority of revenues will still be taxed at the higher 19% rate. The taxable income of most of the top 200 Hungarian companies reaches several billion forints, he noted.
While the introduction of the 10% rate is a positive development, crisis taxes were not exactly welcomed by the sectors affected. “I believe that the government has learned a lesson from the introduction of these taxes and, for instance, it will modify the financial sector tax in cooperation and in agreement with the Banking Association,” Lőcsei said. “According to the National Economy Ministry, the government will follow the developments concerning the bank tax in the EU and will act accordingly.”
Currently, ten EU countries have introduced bank taxes. The Hungarian economy would suffer serious repercussions if the government were to introduce new crisis taxes, Lőcsei said. This would annul all the positive developments made so far, he added.
Room to maneuver
The Hungarian tax system is unlikely to go through further major changes, as it has been basically harmonized with EU directives, according to Lambert. Although the government recently decided not to join the Competitiveness Pact, the basic structure is very similar. “I think that the official explanation for not joining the Pact, that is, that the government did not want to endanger Hungary’s competitiveness resulting from the recently introduced 10% rate, is false, as harmonizing corporate tax rates was not even an issue,” Lambert said.
The Pact was about unifying the determination of the corporate tax base throughout the EU, which would make tax rates comparable. “While a 10% corporate tax rate may sound good, the effective tax rate could be significantly higher, even over 20%, if we calculate with all the items to be added to taxable income.”
The real reason for not joining the Pact is that it would have certainly resulted in a narrower maneuvering room for the Hungarian government in tax issues, Lambert said. By modifying the tax base, the government is able to subsidize certain sectors, activities or investors, he added.
The government said that the harmonization of the corporate tax system is not in the interest of Hungary, as its economic policy aims at attracting more investors to the country. In order to reach this objective, the current high tax burden needs to be curtailed. Furthermore, the Széll Kálmán Plan contains even more ambitious measures, while keeping the independence of the tax system.
Taxes and the Constitution
Article 40 of the new constitution says that “the fundamental rules of general taxation and the pension system shall be defined by a cardinal Act” in order to improve predictability. How exactly this will affect the tax system is not clear yet, as legislators have just started working on the details of the 30 cardinal acts. “I would say that the cardinal act on finances may include some basic principles, such as the competitiveness of the tax system, but I do not expect the rules to be too restrictive,” Lőcsei said.
While this could enhance predictability, governments always like to ensure some room for maneuver regarding taxes. “Therefore, I am pretty sure that changing tax rules will not require a two-thirds majority,” he added. Lambert agrees, saying that the new constitution will probably not have a significant impact on the tax system, except for improving predictability.
Foreign investors are more attracted to a transparent business environment than to lower tax rates. In this area, Hungary has had a huge deficit under every government since the transition. He cited some “creative” examples, which have seriously hurt investor confidence, such as frequently changing VAT rates, implementing the Robin Hood tax and the crisis taxes, and introducing a 98% tax on severance pay with retroactive effect. The new constitution puts more emphasis on the obligations of the people, Lambert said. It says that everybody is obliged to work “to the best of his or her abilities and potential” rather than just simply having the right to work. This is in line with the government’s plan to significantly increase employment.
There has been debate about Article N of the new constitution, Lőcsei noted, which says that Hungary should enforce “the principle of balanced, transparent and sustainable budget management.”The controversial paragraph is that “in the course of performing their duties, the Constitutional Court, courts, local governments and other state organs shall be obliged to respect this principle.”
According to some extreme opinions, courts and the tax authority, which are state organs, will proceed primarily in line with this principle rather than with tax regulations, Lőcsei said, adding that he does not agree with these views. Disregarding tax laws in the interest of the central budget would be a rather dangerous practice, he added.
Hungary has taken the first step in reforming its tax regime by introducing a new personal income tax system, abolishing ten “small-scale” taxes and reducing the corporate tax rate to 10% up to a tax base of HUF 500 million, said the National Economy Ministry. These decisions were only the beginning of the changes needed to increase competitiveness.
Accordingly, in the forthcoming years Hungary is planning to further strengthen its position in the regional tax competition.The next logical step would be the reform of social security contributions, Lőcsei said. He believes that there is a chance that such a reform could be introduced as of January 1, 2012. The options include the introduction of a cap on social contributions for employers or lower rates.
Companies just want to decrease their labor costs, including the total amount of their social security contributions, no matter whether it is through a cap or a lower rate, he noted. The main question is how the reform could be financed. The government will have to take into consideration the revenue fallout from lowering the personal income tax rate as well as changes in social security expenditures, such as the overhaul of the disability pension system and other measures.
According to Lőcsei, it makes little sense to only slightly reduce social security contributions. If the government decides to reform the system, it has to be radical. There are several areas where the government’s intentions are still unclear, according to Lőcsei. The system of environmental product fees is expected to be revised; however, he believes that this should happen in a way that does not put the taxpayers in a difficult situation. Revenues from such fees reached HUF 18.5 billion in 2010. The introduction of taxing online gambling is also underway.
Lőcsei expects changes in vehicle registration taxes as well. “The government does not like the fact that more and more Hungarians drive cars with foreign number plates,” he stressed. He believes that stricter control and the potential decrease of the tax is needed to solve the problem. “The tax will not be eliminated though, as it protects the country’s car fleet from aging,” he added. Vehicle registration tax revenues were HUF 30 billion in 2010.
Experts agree that the system of local business taxes is ready for reform as well. However, as it is closely connected to the reform of the entire local government system, no new measures are expected in the short run. The government reportedly plans to redirect certain local taxes into the state budget, including the local business tax, the vehicle tax and the tourism tax.
Lőcsei pointed out that municipalities are not in great shape and there are substantial differences in their revenues depending on whether there is a major local taxpayer or not. This is a sensitive political issue, as local governments are quite worried about losing this source of income. There was debate over a similar tax in Italy a few years ago, Lambert said. The European Court of Justice eventually ruled in 2006 that Italy was entitled to levy the so-called regional tax on production, because it was different from value-added tax and hence compatible with EU law.“I believe that the future is centralization in such a small country as Hungary,” Lőcsei said.
However, the new regime needs some kind of system of guarantees, which helps municipalities accept the reform. The government is not likely to reintroduce property taxes, Lambert said. “I believe that taxing high-value properties could reach some of those who still manage to avoid paying income taxes.”
There are disadvantages too, as it could lead to social injustices in some cases. Hungary’s Constitutional Court ruled last year that the parts of a tax law on high-value properties affecting homes were unconstitutional.“I do not see a VAT decrease, this is not the time to reduce the main source of budget revenues,” Lőcsei noted.
This article appeared in the BBJ's Law & Tax special report on May 6, 2011.