Sunday, February 17, 2008


When studying and/or doing a job in macroeconomics, it is important to keep an eye on three key features: economic growth, inflation and unemployment. Macroeconomic analysis also emphasized the stability of macroeconomic aggregates such as GDP, public spending and budget consumption. An article Tax tinkering won't fix Hungary's growth problem published by The Guardian briefly outlined Hungary's macroeconomic turbulence in terms of low growth, high government spending and pretty high unemployment rate. Hungary's economy is facing significant macroeconomic problems. In third quarter of the year, Hungary's output grew by as little as one percent (link). In addition, fiscal issues accelerated the fragility of macroeconomic stability.

Tax reform: evidence from Sweden and Iceland

From previous decade onwards, tax reforms have become the guideline of macroeconomic policy. Significant tax cuts on labor supply, entrepreneurship and savings boosted the competitiveness and growth performance in those countries that implemented rigorous economic reforms. In Iceland, the combination of the lower government spending and tax cuts on personal and corporate income generated the Laffer Curve effect, when tax revenues were higher (in the share of the GDP) while tax rate on corporate income was lower (link). Sweden imposed substantial marginal tax cuts and tax revenues grew substantially in the share of the GDP (link).

Don't expect significant Laffer Curve effect in case if public spending is not reduced substantially

As a successful "case-study" of macroeconomic and microeconomic transformation into a market economy, Hungary (link) welcomed foreign investment by slashing the corporate tax rate to the lowest level in Europe, after Ireland and Cyprus. However, Hungary's policymakers decided to build a model of economic policy based on high government spending (link) and resumed budget deficit. The main source of the issue is not budget deficit itself, but the size of government spending in the share of the GDP. Including transfer payments and consumption, Hungary's government spending is extremely high. In recent year it equaled 49,5 percent of the GDP.

High marginal tax rates lead to tax evasion and underground economy

Hoping to restore revenue increases after imposing tax cuts on productive activity in the absence of lower government spending is hopeless nevertheless. Discretionary fiscal policy, high marginal and overall tax rates and highly volatile public finance besides high public expenditures are the main reasons why tax evasion occurs. Tax evasion is nothing else but the consequence of the fact that investors and individuals perceive the opportunity cost of high tax rates as significant. The usual effect of high and marginally progressive tax rates is that tax evasion accelerates the establishment of informal sector known as grey or underground economy. In Hungary, grey economy equals an estimated 17-18 percent of the GDP (link).

Hungary in regional competition

Slovakia (link), Hungary's neighbor went through a period of pro-growth economic and tax reforms. Tax rate on personal and corporate was slashed to flat 19 percent and government spending, including consumption and transfer payments, was reduced substantially. As a result, Slovakia became the Monaco on Danube, a high-growing Eastern European economy known as investment haven. A significant number of international companies such as Peugeot, Citroen and Volkswagen set their production establishments in Slovakia. Also, Slovakia's economy experienced a robust, non-inflationary output growth while Slovakia's macroeconomic institutions streamlined competitive, non-discretionary and stable macroeconomic policy based on expenditure cuts and growth agenda. Hungary has been losing its investment potential subject to abovementioned reasons. Recently, two companies - Audi AG and Servier - have taken alternative consideration of their operations location because of Hungary's statist tax system (link) and discretionary macroeconomic policy.

Reform or die slowly

In 2007, Hungary imposed the 3rd highest tax hike on labor supply in OECD. This could be a substantial incentive for tax evasion. Consequently, productivity growth would definitely stagnate. Timid initiatives to impose tax reform are completely useless unless government spending is cut radically. As a consequence, there would be much less pressure on budget deficit which is estimated to drop from 9,2 percent of the GDP to 4 percent of the GDP. However, deficit is often the wrong number. Also, social security contributions present a persistent barrier to employment and job growth. Long and generous unemployment periods do not create a job-seeking. Nonetheless, the combination of high unemployment and low growth is a deadly situation where the risk of stagnation is huge in case if substantial pro-growth reforms are not implemented. As an economy in transition, Hungary's macroeconomic policy will have to cut spending radically or it will quickly become the France of Eastern Europe (link).

Rok SPRUK is an economist.

Copyright 2008 by Rok SPRUK

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