EUROPEAN COMMISSION Brussels, 23.5.2018 SWD(2018) 368 final COMMISSION STAFF WORKING DOCUMENT Accompanying the document Recommendation for a



COUNCIL RECOMMENDATION with a view to correcting the significant observed deviation from the adjustment path toward the medium-term budgetary objective



in Hungary {COM(2018) 431 final}



COMMISSION STAFF WORKING DOCUMENT Accompanying the document Recommendation for a COUNCIL RECOMMENDATION with a view to correcting the significant observed deviation from the adjustment path toward the medium-term budgetary objective in Hungary 1.Introduction On 21 June 2013, the Council abrogated its decision on the existence of an excessive deficit in Hungary, on account of its correction in 2012, which, based on the Commission 2013 spring forecast, appeared durable. Since then Hungary has been subject to the preventive arm of the Stability and Growth Pact, which requires sufficient progress towards the member state's medium-term budgetary objective (MTO). Hungary is also subject to the debt rule as its general government debt remains above 60% of GDP. On 12 July 2016, the Council addressed recommendations to Hungary in the context of the European Semester. In particular, in the area of public finances the Council recommended Hungary to achieve a fiscal adjustment of 0.6% of GDP in 2017 unless the medium-term objective (MTO) was respected with a lower effort. Based on the Commission 2018 spring forecast, Section 2 of this document presents the macroeconomic and fiscal developments in 2017 and an outlook. Section 3 presents an assessment of compliance with the obligations stemming from the Stability and Growth Pact, including an overall assessment of the reasons for the deviation with respect to the preventive arm requirements. Section 4 proposes the necessary fiscal effort for 2018 to address the significant deviation, including an applicable expenditure benchmark rate compatible with the suggested annual improvement in the structural balance. Section 5 provides the overall conclusions. 2.Macroeconomic and fiscal developments in 2017 and outlook In 2017, real GDP growth accelerated to 4.0%, from 2.2% in 2016, supported also by expansionary fiscal policy. The rebound in GDP growth was helped by tax reductions and increase in public investment. In addition, private consumption benefitted from a strong labour market and large administrative wage increases. Export growth accelerated, supported by the revival of the main export markets. A strong growth of domestic demand raised imports by an even larger amount, resulting in a negative contribution of net exports to GDP growth. The considerable reduction of employers' social security contribution mitigated the pass-through of wage increases to inflation; nonetheless consumer prices accelerated from 0.4% in 2016 to 2.4% in 2017. The Commission 2018 spring forecast projects GDP growth to remain at 4%, before moderating to 3.2% in 2019. Cyclical factors, which are currently supporting growth, are expected to gradually wear off. Investment is expected to stabilize at a high level; with further investment limited by capacity shortages in construction. As readily available labour reserves are exhausted and unemployment falls to record low levels, job creation is projected to slow down. In addition, tailwinds from administrative wage increases are projected to gradually wear off, dampening real wage dynamics in 2019. The moderation of income growth is set to slow down private consumption growth in 2019. Based on the estimates of the 2018 Commission spring forecast, Hungary's positive output gap is calculated to have widened in 2017, to 1.6% of GDP from 0.3% in 2016. Projected GDP growth remains above the potential in 2018 before falling below potential in 2019. With an output gap exceeding 1.5% of GDP, the economy is assessed to be in 'good times' in 2017-2019. Table 1: Macroeconomic developments and forecast 2017-2018



In 2017, the general government deficit rose to 2.0% of GDP, from 1.7% of GDP in 2016. In structural terms, this corresponds to a significant loosening of the fiscal stance with the structural balance estimated to have deteriorated from around -1.8% of GDP in 2016 to below -3% in 2017 (see Table 2). While the economy grew above its potential and at a high nominal rate, public finances were also helped by one-off receipts from agricultural land sales (0.4% of GDP, recorded as negative expenditure). In addition, government revenues benefited from a temporary extra corporate income tax payment (amounting to 0.6% and 0.7% of GDP in 2016 and 2017, respectively). Despite the robust growth of major tax bases, the tax-to-GDP ratio dropped by 0.9% of GDP in 2017. This resulted from sizeable tax cuts, most notably (i) a 5 pps. reduction of the employers' social security contribution rate, (ii) a lowering of the corporate income tax, and (iii) decreasing VAT rates for selected items (see Table 3). The negative effect of tax cuts on revenues was partly compensated by extra income-related tax receipts as a result of accelerating wage increases induced also by a minimum wage hike and a reduction in social contributions. In parallel, government spending rose strongly. Aside from the increased spending on programmes fully matched by EU funds revenue, primary expenditure grew just slightly below nominal GDP (at 7.6% compared with 7.8%). The observed high growth in expenditure reflected measures, such as public sector pay raises, as well as the steeply increased spending on public investment projects. At the same time, interest outlays declined, even in nominal terms, providing a considerable deficit-moderating effect (0.4% of GDP).

The 2017 budget deficit remained below the 2017 Convergence Programme target of 2.4% of GDP. Whereas EU fund absorption fell short of planned, revenues from taxes and other sources exceeded the targets. On the expenditure side, spending on goods and services turned out to be significantly lower than expected. These deficit-improving developments were partially absorbed by higher-than-planned capital expenditure financed from domestic sources and extra spending on public wages and social transfers. Looking ahead, the Commission 2018 spring forecast projects the headline deficit to peak at 2.4% of GDP in 2018. Further tax cuts, particularly an additional 2.5 pps. lowering of employers' social security contribution rate and continued selective VAT reductions, are expected to have a negative impact on the tax-to-GDP ratio. In addition, a significant deficit-increasing effect is projected to arise from the phasing-out of temporary revenues (i.e. land sales and the corporate tax windfall), which benefited the budget during 2016 and 2017. At the same time, overall primary expenditure (without EU funds) is projected to increase moderately relative to the forecast high nominal GDP growth, albeit still well above inflation. Thus the forecast slowdown in spending growth partly offsets the impact of the above-mentioned deficit-increasing developments in 2018. Based on a no-policy-change scenario, the government deficit is projected to decrease to 2.1% of GDP in 2019. In the 2018 Convergence programme, the Hungarian authorities plan a headline deficit of 2.4% of GDP in 2018, in line with the Commission forecast, and a deficit of 1.8% of GDP in 2019, somewhat below the no-policy-change projection of the Commission. Both the total revenue and total expenditure planned for 2018 are higher than in the Commission forecast (see Table 2). The underlying macroeconomic projection of 4.3% of real GDP growth in 2018 is more optimistic than the Commission 2018 forecast, with a positive impact on tax receipts. Compared to the Commission forecast, the government target also counts on higher extra tax revenues generated by increased wage growth, due to further minimum wage increases and social security cuts. On the expenditure side, the planned public investment spending is notably higher. The lower public investment projection in the Commission forecast is based on assuming lower-than-planned EU fund absorption and slower implementation of projects financed from domestic sources, taking into account the increasing capacity constraints in construction. Table 2: Composition of the budgetary adjustment Table 3: Main discretionary revenue measures included in the Commission 2018 forecast (fiscal impact in % of GDP) Title 2017 2018 2019 Reduction of employer's social security contribution (SSC) rate combined with the alignment of SSC allowances to the reduced rates (a rate reduction from 27% to 22% in 2017 and to 19.5% in 2018) -1.4% -0.75% Extra payroll tax/SSC revenues due to minimum wage increases – direct, static effect (general wage minimum: 15% rise in 2017 and 8% in 2018; skilled workers: 25% rise in 2017 and 12% in 2018) +0.35% +0.1% Reduction of the corporate income tax (replacing the two-bracket schedule with 10% and 19% tax rates with a single 9% rate) -0.4% Selective VAT rate cuts (2017: poultry, milk and eggs from 27% to 5%, restaurant meals and internet from 27% to 18%; 2018: fish and pork liver from 27% to 5%; restaurant meals and internet from 18% to 5%) -0.2% -0.2% Measures to increase tax collection efficiency (the extension of online cashiers in services and the phasing-in online invoicing between companies) +0.15% +0.05% Note: The budgetary impact in the table as included in the Commission 2018 spring forecast. A positive sign implies that revenue increases as a consequence of this measure. The table includes measures with a fiscal impact of at least 0.1% of GDP over the examined period.



Table 4: Debt developments In 2017, the government debt-to-GDP ratio declined by 2.4% of GDP, reaching 73.6%. This decrease was mainly driven by a favourable snow-ball effect reflecting the acceleration of nominal GDP growth and helped also by the primary surplus, while it was adversely affected by below-the-line developments (i.e. stock-flow adjustments). The Commission 2018 spring forecast projects a slowdown in the rate of debt reduction in 2018 due to an additional sizeable stock-flow adjustment effect, with the debt ratio decreasing only slightly to 73.3%. Thereafter, the debt ratio is projected to decline faster, falling to 71% in 2019 thanks to persisting high nominal GDP growth. The authorities' updated debt projection is broadly in line with the Commission forecast for 2018, while the authorities expect a lower debt ratio by the end of 2019 relative to the Commission, mainly on account of a higher GDP growth projection. In 2017, Hungary is calculated to have complied with the debt rule as the debt-to-GDP ratio remained below the debt-reduction benchmark. A similar conclusion is reached for 2018 and 2019 on the basis of the updated national plans and the Commission 2018 spring forecast. 3.Compliance with the adjustment towards the MTO in 2017