TAX NEWS - June 2010

Hungary tax cuts

Tax cuts could boost Hungary's growth and make its finances more sustainable but the government must first deliver on budget goals to regain investor confidence shaken by ill-worded comparisons with Greece.

Hungary was the first European Union country to need International Monetary Fund help when the global crisis deepened in 2008, and will probably need to keep some kind of IMF safety net even after its current IMF/EU loan expires in October 2010.

Although the new government's measures announced on Tuesday include some that pose risks to growth in the near term, the planned tax cuts could boost growth a few years down the line by discouraging illegal employment and improving tax compliance, ultimately making it easier to reduce the country's debt burden.

"The important thing is that Fidesz (ruling party) gets the sequencing right: the government must first show that they can reduce the deficit and thereby reduce debt," said Christian Keller at Barclays in London.

"Then confidence will be established and better growth will help to make the further debt reductions even simpler -- a virtuous cycle."

The centre-right government, seeking to banish the spectre that officials raised last week of a Greek-style debt crisis, proposed steps which include a flat 16 percent income tax, a hefty tax on banks, and a ban on new foreign currency lending.

While much depends on the details, analysts said plans such as the flat income tax and a cut in the corporate tax on small and medium firms to 10 percent will bolster longer term growth.


TAX EVASION

However the tax on banks and the ban on foreign currency loans will curb lending and hamper growth in the short term. A planned freeze in public sector costs and a cut in some public wages could also hurt domestic demand this year.

"In the short term, I don't think this package will boost demand next year in the economy, but on the whole the incentives in the tax regime to work more and employ more people legally could move things in a positive direction," said Zsolt Kondrat, economist at MKB Bank in Budapest.

Eszter Gargyan at Citigroup said tax cuts could give consumption a one-off boost but other measures could partly offset that. "Long-term competitiveness gains may also require structural reforms in the labour market and a stable economic environment," she added.

Hungary's economy shrank by 6.3 percent last year, but grew 0.9 percent in the first quarter compared to the last quarter of 2009 thanks to rising exports and manufacturing.

Once a magnet for foreign investment in central Europe, Hungary's competitive edge has eroded partly due to its high labour tax wedge, which according to the OECD was smaller only than Belgium's in the EU, at around 55 percent in 2008.

High taxes have built a black economy. About 740,000 of Hungary's 10 million people work in the state sector and in the private sector hundreds of thousands -- some just on paper, to evade taxes -- are employed on the minimum monthly wage of 73,500 forints ($374).

The previous Socialist government cut employers' social taxes to 27 percent from 32 percent, but a February OECD report said tax remains "exceedingly high" and described "a classic vicious circle of burdensome taxation that induces evasion and participation in the grey economy."


IMF FINANCING ANCHOR

The government wants to collect 200 billion forints from the financial sector through a new tariff this year alone.

It also wants to ban foreign currency lending -- an engine of domestic demand which turned into a huge vulnerability.

"We view a three-year bank tax ... as negative for growth," said Peter Attard Montalto at Nomura.

But Hungarians, who endured their second major austerity package last year since the 1989 collapse of the communist regime, have welcomed an income tax cut and are cautiously optimistic.

"Maybe we'll be able to pay our mortgage easier. It has been pretty tough for us. Although ... I'm sure the banks will pass on their own extra tax to us," said Eva Kelemen, 40, a teacher in Budapest.

"I will surely be better off with a 16 percent flat income tax," said Beatrix Vegh, who works in the private sector.

Investors, who had high hopes for the new government after April elections, want to see it honour this year's 3.8 percent deficit target and control the deficit next year as well.

Even then, they want Hungary to agree a new deal with the IMF, given a public debt burden of around 80 percent of gross domestic product.

"If the government presents an acceptable economic plan, market funding is likely to be sufficient to cover public funding needs," said Gargyan at Citigroup.

"Nonetheless, given the uncertainties related to global financing conditions and the weak credibility of the government, the renewal of the IMF program is likely to ... provide an anchor for investors and a funding buffer in case of severe tightening in external liquidity conditions."