VZCZCXRO9904
RR RUEHAG RUEHDF RUEHIK RUEHLZ RUEHROV RUEHSR
DE RUEHUP #0006/01 0051619
ZNR UUUUU ZZH
R 051619Z JAN 09
FM AMEMBASSY BUDAPEST
TO RUEHC/SECSTATE WASHDC 3751
RUEATRS/DEPT OF TREASURY WASHDC
INFO RUCNMEM/EU MEMBER STATES COLLECTIVE
RUCPDOC/DEPT OF COMMERCE WASHDC

UNCLAS SECTION 01 OF 03 BUDAPEST 000006 
 
SENSITIVE 
SIPDIS 
 
DEPT FOR EUR/CE, EB/OMA, INR/EC; USDOC FOR SAVICH; TREASURY 
FOR IRS, ERIC MEYER, JEFF BAKER, LARRY NORTON; USEU FOR 
HAARSAGER 
 
E.O. 12958: N/A 
TAGS: EFIN ECON PREL HU
SUBJECT: ECONOMIC REFORM ISSUES II: TAX EVASION AND THE 
INFORMAL ECONOMY 
 
REF: BUDAPEST 12011 
 
¶1. (SBU) Summary.  This is the second report on structural 
economic reforms economists and macroeconomic analysts 
believe are needed to help Hungary achieve higher economic 
growth, reduce macroeconomic vulnerabilities, and remain 
economically competitive in the region.  The low tax 
compliance rate and large informal economy in Hungary 
undermines efforts to reduce the budget deficit and reduces 
the amount of funding available for public services.  To 
address this problem, the tax authority is focusing its 
efforts on strengthening enforcement measures and increasing 
public awareness of the role of taxes in society.  Many 
believe that more comprehensive tax reform is needed to 
address the underlying causes of Hungary's low tax compliance 
rate, and that without reform, the situation will only 
marginally improve.  End summary. 
 
TAX EVASION AND THE INFORMAL ECONOMY IN HUNGARY 
 
¶2.  (SBU) Tax evasion and avoidance is a serious problem in 
Hungary, compounding the country's large budget deficit and 
national debt problems by reducing the amount of government 
revenue.  The OECD notes that despite some recent 
improvements, "Hungary suffers from poor tax compliance, 
resulting in significant revenue leakage."  As noted reftel, 
the number of people working in the informal economic sector 
in Hungary is among the highest in the EU.  Although accurate 
statistics are difficult to obtain, the most commonly cited 
estimate is that income produced by the illegally employed 
makes up more than 20 percent of Hungary's GDP.  By contrast, 
the EU-15 average was estimated to be 6.4 percent in the year 
¶2000.  In 2006, the size of the hidden economy in Hungary was 
estimated to be around HUF 4,000 billion (USD 20 billion), of 
which HUF 1,000 billion (USD 5 billion) would have 
contributed to the central budget. 
 
¶3. (SBU) The 20 percent estimate matches what Hungarian 
Academy of Sciences economist Janos Kollo calls the "first 
guesstimate of gray economic activity in the 1980's." 
Ecostat official Belyo Pal notes that in the 1980's, however, 
the backbone of the shadow economy in Hungary was the 
unofficial business activity of private individuals, but that 
from the 1990's, tax evasion and unregistered business 
activities of enterprises were the key factors in the hidden 
economy.  Areas where businesses are commonly reported to 
abuse the system include the employment of unregistered 
workers and the use of fraudulent accounting practices 
(fictitious invoices, hidden petty cash, carouseling 
invoices, etc).  Although only 46 percent of company managers 
admitted to the existence of a black market in a recent 
Ecostat poll, of this number, over 40 percent admitted to 
having unregistered employees.  Another common way in which 
companies reportedly avoid paying taxes is by paying their 
employees the monthly minimum wage of HUF 69,000 (approx. USD 
350) and then supplementing it with under the table payments 
or by refunding VAT receipts for goods bought by employees in 
the company's name. 
 
¶4. (SBU) Lost tax revenue not only impacts the Hungarian 
government, but those relying on government services as well. 
 Hungary is currently subject to EU excessive deficit 
procedures, and for the past two years, the country's 
macroeconomic policy has been focused on fiscal 
consolidation.  High levels of tax evasion and avoidance 
undermine this objective by reducing the level of revenue 
coming into state coffers and making it more difficult for 
the government to provide important services to citizens.  A 
large informal economy also skews Hungary's official 
employment rate statistics, giving the appearance of a less 
active population than is actually the case. 
 
WHY IS TAX EVASION AND AVOIDANCE SO HIGH? 
 
¶5. (SBU) Although tax compliance issues exist in every 
country, economists and other observers suggest a number of 
reasons why levels of tax evasion and avoidance are 
particularly high in Hungary, including: 
 
ECONOMIC NEED. The average person would likely cite economic 
necessity as the main reason Hungarians cheat on their taxes. 
 Many maintain that low wages coupled with a high cost of 
living and high tax rates make tax evasion an unavoidable 
reality for many people.  The same is often said for small 
businesses, which many argue are "driven into the gray 
 
BUDAPEST 00000006  002 OF 003 
 
 
economy" by high taxes, and that unless they find some way to 
avoid paying taxes, many would lose economic viability and be 
forced to close. 
 
POLITICAL DISSATISFACTION. Another common explanation for 
high levels of tax avoidance is that there is a high level of 
distrust of the government, and many do not believe the 
government will use taxpayer money responsibly or in a manner 
consistent with their views on how public resources should be 
allocated.  Whether true or not, it is widely believed that 
revenue generated through taxes is either wasted, 
misallocated, or even pilfered by unscrupulous politicians. 
 
STRUCTURAL DISINCENTIVES.  As noted reftel, Hungary's current 
income tax rate structure, with steep jumps between tax 
brackets, creates incentives for the underreporting of 
income.  GKI Research Institute Deputy CEO Gabor Karsai notes 
that the taxation system of employment makes the employment 
of people with medium or higher qualifications "astonishingly 
expensive," and is "both a reason and a consequence for the 
widespread gray and black labor market."  In addition, the 
narrow gap between the minimum wage and the amount that can 
be received through the social welfare system creates an 
incentive to work on the informal economy while continuing to 
collect social welfare benefits.  Ironically, contacts in the 
civil sphere admit that this phenomenon extends even to NGOs, 
where officials are often dual-hatted...and double-dipping. 
 
HISTORICAL TRENDS/TAX MORALITY.  Debrecen University 
professor Dr. Tibor Glant argues that the economic 
liberalization of the 1980's, while allowing limited private 
enterprise, also encouraged the growth of the hidden and 
informal economy, as uncertainty regarding the government's 
commitment to market-oriented reforms caused many to keep 
private economic activity out of sight of the government.  If 
true, the market-oriented reforms that gave Hungary a 
head-start in the region following Hungary's transition to a 
Western-style parliamentary democracy may be contributing to 
the large informal economy in Hungary today.  Others argue 
that Hungary's tradition of tax avoidance dates back even 
further to the Austro-Hungarian empire, when Hungary was 
required to pay taxes to the monarchy in Vienna.  Prime 
Minister Gyurcsany himself has commented privately that 
Hungary has yet to overcome the mindset that "taxes have 
always paid for foreign occupation so tax evasion has always 
been a patriotic duty." 
 
WEAKNESSES IN TAX ADMINISTRATION.  Still others argue that 
people avoid paying taxes simply because they are able to get 
away with it.  Miklos Kok of Hungary's tax administration 
(APEH), quipped that there "is no limit to the creativity of 
the Hungarian people in finding ways to avoid paying taxes." 
He notes that today it is even considered "fashionable" by 
many to avoid paying taxes.  According to Kok, the major 
thrust of APEH's efforts to improve tax compliance is to 
close loopholes and increase the penalties for intentional 
tax evaders (see below). 
 
COMPLICATED TAX SYSTEM.  APEH officials admit that Hungary's 
complicated tax system leads to a fairly high level of 
unintentional underreporting of income.  As FIDESZ Party 
President Viktor Orban recently vented, "I have only my 
salary - so why should I need an accountant?"  The government 
is working to address this both through a simplification of 
the tax rules, as well as through tools to assist taxpayers 
in better understanding tax laws. 
 
GOVERNMENT RESPONSE: EDUCATE THE PUBLIC AND CARRY A BIG STICK 
 
¶6. (U) The government's primary response to the problem of 
tax evasion and avoidance has been to increase and improve 
its investigative capacity and to increase civil and criminal 
penalties for tax evaders.  In recent years APEH has 
increased the number of checks on individuals' income tax 
declarations, and has hired more labor inspectors to check 
salary arrangements.  Hungary's recently passed 2009 tax 
package includes higher penalties and new compliance 
requirements.  APEH officials tell us there is an increased 
focus on risk assessment, and that audits and labor 
inspections are now being carried out in a more targeted way. 
 There has also been a growing use of indirect tools, 
including the use of minimum tax rules.  For example, in 
2006, Hungary set a "double minimum wage rule" whereby 
employers are required to pay contributions on double the 
minimum wage unless they can prove the employee is paid less 
 
BUDAPEST 00000006  003 OF 003 
 
 
than this amount.  The government has also announced a "tax 
lottery" to encourage people to request VAT receipts in order 
to increase VAT compliance rates. 
 
¶7. (U) Although many complain that the government is too 
heavily focused on the enforcement of tax rules and not on 
positive incentives like tax relief and the simplification of 
tax rules, increased enforcement has had some success.  In 
2007, the increased investigative capacities of the tax 
authorities on wealth statuses and personal income tax 
declarations reportedly resulted in extra tax revenues of 
approximately 0.3 percent of GDP. 
 
¶8. (U) Economists caution, however, that exclusively focusing 
on strengthening enforcement could result in reduced 
disposable income for individuals and higher labor costs for 
businesses, which in turn could affect levels of consumption, 
exports, and growth.  The OECD agrees that punitive measures 
can only be successful to a point, noting that "while efforts 
to reduce tax evasion and strengthen tax administration and 
collection have yielded positive results and should be 
continued," the prospects for further reducing the gray 
economy "would seem to require a substantial reduction of the 
tax wedge on labor." 
 
¶9. (U) APEH officials admit that enforcement alone is not 
enough, and have increased efforts to educate the public on 
the role of taxes in society through public school and direct 
media campaigns.  In addition, APEH is trying to become more 
customer service oriented by simplifying the tax paying 
process and reducing the administrative burden on taxpayers. 
 
A DIFFICULT ROAD AHEAD 
 
¶10. (SBU) Comment.  Having undergone a significant 
restructuring in 2007, in which 23 district tax offices were 
consolidated in 7 tax directorates, APEH is quickly improving 
its enforcement capacity, resulting in improved compliance 
rates and higher revenue for the state.  But the system they 
are enforcing remains inordinately complicated, and the 
organization's attempts to win over the hearts and minds of a 
skeptical population that believes it is paying more into the 
system than it is getting out of it have not been as 
successful.  Internal scandals and embarrassments have not 
helped APEH'S public image either, and have undermined both 
objectives.  For example, in September a senior APEH 
inspector was arrested on suspicion of receiving bribes in 
exchange for providing favorable results on wealth inspection 
reports.  In addition, the tax authority was the subject of 
much public jesting in November when it announced it would 
not hire new workers with an IQ of less than 90 (the average 
human possesses an IQ of 100). 
 
¶11. (SBU) Comment continued.  Although many welcome GoH 
public outreach efforts to educate the public and help 
increase public willingness to pay taxes, they believe the 
Government's focus on stricter enforcement can only go so far 
in reducing the size of the informal economy.  The key, they 
believe, is to overhaul the tax system by simplifying tax 
regulations, reducing the tax burden and making it more 
equitable, and reducing the marginal differences between tax 
brackets.  Until this happens, however, a significant share 
of potential tax revenue will continue to be lost to the gray 
economy.  End comment. 
Foley