VZCZCXRO8207
RR RUEHAG RUEHDF RUEHIK RUEHLZ RUEHROV RUEHSR
DE RUEHUP #1201/01 3520844
ZNR UUUUU ZZH
R 170844Z DEC 08
FM AMEMBASSY BUDAPEST
TO RUEHC/SECSTATE WASHDC 3699
RUCPDOC/DEPT OF COMMERCE WASHDC
RUEATRS/DEPT OF TREASURY WASHDC
INFO RUCNMEM/EU MEMBER STATES COLLECTIVE

UNCLAS SECTION 01 OF 02 BUDAPEST 001201 
 
SENSITIVE 
SIPDIS 
 
DEPT FOR EUR/CE, EB/OMA, INR/EC; USDOC FOR SAVICH; TREASURY 
FOR ERIC MEYER, JEFF BAKER, LARRY NORTON; USEU FOR HAARSAGER 
 
E.O. 12958: N/A 
TAGS: ECON EFIN PREL HU
SUBJECT: ECONOMIC REFORM ISSUES I: THE TAX WEDGE 
 
¶1. (U) This is the first in a series of reports on structural 
economic reforms proposed by economists and macroeconomic 
analysts to help Hungary achieve higher economic growth, 
reduce macroeconomic vulnerabilities, and to remain 
economically competitive in the region. 
 
THE HIGH TAX BURDEN ON LABOR 
 
¶2. (SBU) The high tax burden on labor often tops economists' 
lists of areas in which structural economic reform is needed 
in Hungary.  Taxes on labor influence both workers' decisions 
about how much labor they supply, and firms' decisions about 
how much labor they employ.  Critics complain that Hungary's 
current labor tax rules discourage employment, encourage the 
under-reporting of wages, and stifle the economic growth 
potential of businesses.  They assert that if not addressed, 
Hungary will at best continue to be the economic laggard of 
the region, or at worst, it could face a new financial or 
economic crisis as investor confidence and Hungary's business 
climate continues to erode. 
 
¶3. (U) The OECD reports that the tax wedge in Hungary - the 
difference between an employee's net take-home pay and the 
cost of their employment, including income taxes and social 
security contributions - is the second-highest in the OECD, 
falling only behind Belgium.  In 2007, single workers in 
Hungary without children earning the average wage in services 
and manufacturing industries faced a tax wedge of 54.4 
percent of the cost of their labor.  The average for OECD 
countries was 37.7 percent. 
 
¶4. (U) Although the personal income tax rate in Hungary is 
not the highest in the EU (ranging between 18 and 40 
percent), Hungary's large tax wedge also comes from employee 
and employer contributions to the social welfare system. 
Hungary's national bank agrees, noting that Hungary's high 
labor burden for employers and employees is due to "extremely 
huge social security contributions."  In general, employers 
pay approximately 29 percent of their employees' income for 
pension and health care contributions, and individuals pay an 
additional 17 percent. 
 
¶5. (U) Worse still, the size of the tax wedge in Hungary is 
growing.  Between 2006 and 2007, the tax wedge in Hungary 
grew more than in any other OECD country (2.5 percent).  In 
addition, the government is becoming increasingly reliant on 
taxes on labor as a source of revenue, likely making future 
reforms more difficult.  Oriens Capital Investment notes that 
the share of taxes on labor in the total government budget 
increased from 45 percent in 2004 (as a percentage of total 
government revenue) to nearly 50 percent in 2007. 
 
DISCOURAGING EMPLOYMENT 
 
¶6. (U) Economists point out that Hungary's high tax wedge 
discourages employment, and that reducing it is critical to 
increasing an employment rate which is among the lowest in 
the OECD.  According to March 2008 data, Hungary's labor 
force participation rate for people age 15-64 was just 56.3 
percent, well below the regional and OECD average of 70 
percent.  The IMF raised this issue in its latest Article IV 
consultations, remarking that "a shift of the tax burden away 
from labor and to consumption and wealth would improve work 
incentives and boost employment."  In a recent report, the 
Hungarian National Bank recognized that the "large tax wedge 
increases non-employment, or at least diminishes labor demand 
and supply in the formal sectors."  Increasing the level of 
legal employment would generate additional government revenue 
and help offset revenue lost through tax cuts. 
 
¶7. (SBU) Hungary's tax laws also impose a high marginal cost 
on employers who hire more than a certain number of 
employees, discouraging the growth of companies in Hungary. 
Combined with the overall high tax burden on labor, this has 
had the effect in certain industries of promoting the use of 
subcontractors or even illegal workers.  In the construction 
industry, for example, Oriens reports that the average 
construction company in Hungary only employs three people, 
whereas the Slovakian equivalent employs 19, and the average 
Romanian construction company employs 13.  Other analysts 
point to these elements of the Hungarian tax system as the 
reason why there are relatively few large-sized companies or 
franchises of Hungarian origin. 
 
UNDER-REPORTING OF WAGES 
 
¶8. (U) It is also widely believed that Hungary's tax wedge 
 
BUDAPEST 00001201  002 OF 002 
 
 
not only overburdens those paying taxes, but also contributes 
to the high level of tax evasion in Hungary (septel).  Both 
employers and employees have an incentive to underreport 
their actual income.  Estimates of illegal employment in 
Hungary are among the highest in the EU.  In 2004, income 
produced by the illegally employed as a share of GDP was 
estimated to be over 20 percent, and many believe the figure 
to be as high as 30 percent.  By contrast, the EU-15 average 
was estimated to be 6.4 percent in the year 2000. 
 
¶9. (U) The current labor tax system in Hungary also imposes 
high marginal costs on raising salaries above a relatively 
low level, which contributes to an under-reporting of income 
(and subsequently a reduction in government revenue).  Oriens 
points out that under current tax rules, there is a 
significant jump in the marginal costs to employers for 
employees whose gross monthly incomes exceed HUF 150,000 
(approx. USD 750).  The steep increase in marginal costs at a 
relatively low level (the current minimum wage is HUF 69,000 
- approx. USD 345), encourages the non-reporting of income 
above this rate. 
 
¶10. (U) There is also a high marginal cost to employees as 
the personal income tax rate in Hungary jumps from 18 percent 
to 36 percent at a relatively low income level.  Currently, 
earnings below HUF 1,700,000 per year (Approx. USD 8,500) are 
taxed at 18 percent, while earnings above this amount are 
taxed at a rate of 36 percent.  This creates an incentive to 
report only those wages that fall within the 18 percent tax 
bracket, and confirms the assertion of economists that tax 
rates, when combined with corruption, exert a strong 
influence on the size of the hidden economy. 
 
REDUCING DEMAND 
 
¶11. (SBU) The high tax wedge squeeze on households' 
disposable incomes also has the effect of dampening consumer 
demand, which is already suffering from the effects of the 
global economic downturn and IMF/EU stabilization package 
austerity measures.  In Spring 2008, the "big four" tax firms 
and the AmCham presented a series of tax proposals which they 
believe would help boost economic growth, promote additional 
employment, and help reduce the size of the informal economy. 
 The centerpiece of this proposal is a simplification of the 
tax system, which would reduce the tax burden on labor, and 
shrink marginal tax burdens.  They believe the plan would 
immediately result in an increase in GDP growth by 1 percent 
over the current growth plan, and could result in a growth 
rate of 4.5 percent within four years.  Oriens believes 
comparable results are achievable under its plan, which also 
calls for the simplification of the tax system, and a shift 
in the tax burden from labor to consumption. 
 
¶12. (SBU) Comment.  Although recognizing the problems high 
labor taxes create in the economy, the GoH maintains that 
significant tax cuts are not possible in the near term as it 
focuses its attention on meeting deficit reduction targets of 
the IMF/EU stabilization package.  Many economists do not 
believe, however, that tax cuts and fiscal consolidation are 
mutually exclusive, maintaining that a reduction in the tax 
wedge, offset by shifting some of the tax burden to 
consumption, would not be an impediment to fiscal 
consolidation efforts.  They argue that a reduction in income 
from lowering taxes on labor will be offset by increased 
revenues resulting from higher growth rates and lower levels 
of tax avoidance.  End comment. 
Foley