EUROPEAN COMMISSION Brussels, 26.2.2020 SWD(2020) 516 final COMMISSION STAFF WORKING DOCUMENT Country Report Hungary 2020 Accompanying the document COMMUNICATION FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT, THE EUROPEAN COUNCIL, THE COUNCIL, THE EUROPEAN CENTRAL BANK AND THE EUROGROUP 2020 European Semester: Assessment of progress on structural reforms, prevention and correction of macroeconomic imbalances, and results of in-depth reviews under Regulation (EU) No 1176/2011 {COM(2020) 150 final}



Contents Executive summary 1.Economic situation and outlook 2.Progress with country-specific recommendations 3.Reform priorities 3.1.Public finances and taxation 3.2.Financial sector25 3.3.Labour market, social policies, education and healthcare27 3.4. Competitiveness, reforms and investment36 3.5.Environmental sustainability50 Annex A: Overview Table53 Annex B: Commission debt sustainability analysis and fiscal risks62 Annex C: Standard Tables63 Annex D: Investment guidance on Just Transition Fund 2021-2027 for Hungary69 Annex E: Progress towards the Sustainable Development Goals (SDGs)71 References76 LIST OF Tables Table 1.1:Key economic and financial indicators - Hungary

Table 2.1:Assessment of the implementation of 2019 country-specific recommendations (CSRs) Table 3.2.1:Financial soundness indicators Table C.1:Financial market indicators Table C.2:Headline Social Scoreboard indicators Table C.3:Labour market and education indicators Table C.4:Social inclusion and health indicators Table C.5:Product market performance and policy indicators67 Table C.6:Green growth68 Table E.1:Indicators measuring Hungary’s progress towards the SDGs71 LIST OF Graphs Graph 1.1: Contributions to real GDP growth Graph 1.2: Labour productivity and equipment investment Graph 1.3: Participation, unemployment and NEET rates Graph 1.4: Contributions to unit labour cost growth Graph 1.5: Real net disposable income growth between 2008-2018 at different income levels Graph 1.6: Inflation and unit labour cost Graph 1.7: Export market share growth Graph 1.8: Net foreign currency assets by sector Graph 1.9: Decomposition of debt by sector

Graph 1.10: House price to income ratio Graph 2.1: Overall multiannual implementation of 2011-2019 CSRs to date Graph 3.1.1: Development of the GDP growth and fiscal impulse (differences between Hungary and the EU average), 2012-2018 Graph 3.1.2: Change in the structure of the expenditure in Hungary over the last 10 years and the difference, compared with the EU average Graph 3.1.3: Implicit interest rate of public debt in the EU Graph 3.1.4: Central government cash expenditure Graph 3.1.4a:1. Income gap between wage earners and pensioners 2. Inequality of income distribution, 65 years+ Graph 3.2.1: Credit growth Graph 3.3.1: Regional unemployment rate, 2018, % Graph 3.3.2: Employment rate by age and gender in 2018 Graph 3.3.3: In-work poverty rate in groups Graph 3.3.4: Change in the Gini coefficient due to tax and benefit policies: 2008-2018 Graph 3.3.5: Underachievement gap in reading by socio-economic status, percentage points Graph 3.3.6: Ratio of average teacher's gross salary over national gross wages Graph 3.3.7: Unfilled general practicioner practices per 100,000 population by counties, 2018 Graph 3.4.1: Labour productivity relative to the EU average (at PPS) Graph 3.4.2: Employment patterns and domestic value added in gross exports in selected countries Graph 3.4.3: R&D expenditure 37 Graph 3.4.4: Adoption of selected Industry 4.0 technologies (average adoption rate of EU=100) 39 Graph 3.4.5: Assessment of product market functioning in the Global Competitiveness Index 2019 40

Graph 3.4.6: Average of voice and accountability and control of corruption indices in Worldwide Governance Indicator (EU average=100) 44 Graph 3.4.7: Detection of irregularities and their financial impact in the areas of European Structural and Investment Funds and Agriculture in 2014-2018 45 Graph 3.4.8: GDP per head and GDP growth (at purchasing power parity, 2008-2018) 49 LIST OF Boxes Box 2.1: EU funds and programmes to address structural challenges and to foster growth and competitiveness in Hungary Box 3.1.1: Increasing inequalities in the pension system Box 3.3.1: Monitoring performance in light of the European Pillar of Social Rights Box 3.4.1: Investment challenges and reforms in Hungary Box 3.4.2: Challenges and opportunities of the automotive industry in Hungary Executive summary Hungary’s robust economic growth offers a valuable opportunity to engage in important structural and institutional reforms to sustain durable growth over the longer term. In recent years, Hungary has experienced a strong economic expansion with one of the highest GDP growth rates in the EU. Employment has also risen quickly. Hungary’s future economic development depends on the economy’s capacity to increase productivity, which requires a move away from the model based on low labour costs towards a knowledge-based, sustainable economy producing advanced products. Structural and institutional reforms are also needed to ensure the optimal allocation of resources. The current good economic environment creates an opportunity to address the main challenges of the economy, in particular related to the shrinking working-age population, low productivity growth, increasing inequalities and low efficiency of natural resource use ( ). The Hungarian economy continues to grow strongly. Average economic growth since 2014 has exceeded 4% as the economy has recovered from the financial crisis. In 2019, the economy was able to withstand the international growth slowdown, partly thanks to supportive macroeconomic policies. Strong demand for labour has continued to lift employment, while wage growth has remained rapid due to labour shortages and large minimum wage increases. Favourable labour market trends have helped improve living conditions and reduce poverty. Investment has risen to a record level, thanks to a favourable economic outlook, easy financing conditions, supportive fiscal policy and a large inflow of EU funds. The expansion of the economy is set to reach its limits. So far, economic growth has relied on increasing the number of workers, while output per worker has grown modestly. With the labour market near full employment, job creation may contribute less to output growth in the coming years. The lack of available skilled labour is a key obstacle to productivity-enhancing investment and innovation. Plans for a reduced government spending and the low growth of main trading partners may also restrict Hungarian economic growth in 2020 and 2021. Macroeconomic policies have created some risks of overheating. Labour costs, boosted by administrative wage increases, continue to outpace productivity growth. Rising production costs have increased inflation and worsened exporters’ cost competitiveness. Very low real interest rates and homebuying subsidies have contributed to the rapid increase in house prices. Homebuilding has not kept pace with housing demand because of capacity constraints and Budapest’s property market shows signs of overheating. Easy financing conditions, including several government-supported lending schemes, have created opportunities for businesses to invest. However, there is a risk of these resources not being used to support long-term economic growth benefiting society as a whole. Public financial management has tended to increase spending and reduce taxes during good economic times instead of building fiscal buffers. This procyclical fiscal policy, combined with the absorption of EU funds, has contributed to above-EU-average GDP growth over the past years. Fiscal planning remains narrowly focussed on the annual budget, with an increasing role played by budgetary reserves, partly related to the early adoption of the budget. This has repeatedly led to heightened spending at the end of the fiscal year, resulting in public spending on lower quality projects and pro-cyclical fiscal stance. Discretionary measures have also tended to be procyclical while, by design, the tax and benefit system provides a limited cushion against economic cycles. As a result, while the economy continues to perform well, public finances are improving only slowly and in June 2019 the Council launched a new significant deviation procedure addressed to Hungary ( ). Public debt, while decreasing, remains high for Hungary’s income level, with a low duration, relatively high exposure to changes in market interest rates and high refinancing costs. While risks are limited in the near future, the ageing population increases fiscal sustainability risks in the long term. Increased investment in research, innovation, infrastructure and skills are essential for improving productivity and for long-term growth that benefits society as a whole. Public and private investment as a share of GDP is high, but its composition could be better geared towards raising productivity. Research and innovation capacities need to be enhanced to improve moderate innovation performance. Territorial inequality could be alleviated by improving infrastructure and public services in deprived areas. Investment is crucially needed in skills, education and training to boost future economic growth in Hungary. Other relevant investment spending items are childcare, healthcare and social inclusion. Greening the economy requires investment in energy efficiency, climate change resilience and waste management. The institutional framework needs to improve to ensure that the economic and social benefits of these investments are maximised. Hungary has made limited progress ( ) in addressing the 2019 country-specific recommendations.

There has been limited progress in the following areas: ·Policy action to get more people from vulnerable groups into work or training` includes the extension of childcare facilities and measures to enhance the transition from the public works scheme to the primary labour market. The government has announced certain measures to improve health care but these only address the recommendation to a limited extent. The salaries of healthcare professionals have increased and cancer-screening programmes have started. Measures have been introduced to lower the school drop-out rate; however, serious challenges remain related to social mobility. The Hungarian economy allocates an increasing amount of funding to investment in research and innovation and transport but framework conditions remain weak. The government plans to spend more on low-carbon energy and to improve energy and resource efficiency, and measures have been taken to improve waste management. Some legislative changes are intended to improve competition in public procurement but their impact remains to be seen. While some steps have been taken to reduce the complexity of the tax system, no significant additional effort has been made to reduce the risk of aggressive tax planning, apart from the implementation of European legislation. There has been no progress in the following areas: ·No progress has been made in improving the adequacy of social assistance and unemployment benefits. No progress has been made to reinforce the anti-corruption framework, including by improving prosecutorial efforts and access to public information. No progress has been made to address the persisting concerns regarding judicial independence. The regulatory environment in services has not improved. The quality and transparency of decision-making and social dialogue is among the weakest in the EU and no steps have been taken to improve it. Hungary performs relatively well on some indicators of the Social Scoreboard supporting the European Pillar of Social Rights but significant challenges remain. Employment outcomes compare well with EU averages, while the unemployment rate is one of the lowest in the EU. Income inequality is close to the EU average although it has been increasing. Employment and salary gaps between genders and skills groups remain wide compared with the rest of the EU. Labour market outcomes for women and vulnerable groups are below the EU average. Regarding the progress in reaching the national targets under the Europe 2020 Strategy, Hungary is performing well in boosting the employment rate, reducing relative poverty and reducing greenhouse gas emissions. More effort is needed to raise research and development spending, higher education attainment, energy efficiency and renewable energy use and to reduce early school leaving. Overall, Hungary’s performance in achieving the United Nations Sustainable Development Goals (SDGs) is average. Hungary performs relatively well in the indicator measuring decent work and economic growth (SDG 8). However, significant challenges remain, in particular, in improving the quality of education (SDG 4) (). Key structural issues analysed in this report, which point to particular challenges for Hungary’s economy, are the following: ·Despite recent improvement, output per worker remains among the lowest in the EU. Domestic companies mainly contribute to international production chains through assembly-type activities, which add little local value. This specialisation is related to the still moderate innovation performance of the Hungarian economy despite increasing expenditure on research, development and innovation. The shortage of highly skilled workers is a key obstacle to innovation. Cooperation among researchers and businesses is weak, hindering knowledge transfer from abroad, and towards smaller domestic enterprises. Hungary’s adoption of productivity-enhancing digital technologies is among the lowest in the EU, and it is hindered by low digital skills. ·Restrictive regulations and increasing state involvement hinder the proper functioning of the markets. Restrictive product market regulations hamper the evolution of successful businesses, which reduces economy-wide productivity. Selected companies benefit from government support through large subsidies, tailor-made regulations, specific agreements and protection from competition. Frequent regulatory changes lead to an unstable business environment in retail trade and the regulation of professions is still restrictive. The tax system remains complex even after simplification efforts, and there are indications that the country’s corporate tax rules may be used for aggressive tax planning. ·The institutional and governance framework affects the business environment and the optimal allocation of resources. Over the past years, institutional quality and legislative predictability have been relatively weak and deteriorating compared with both the EU average and Hungary’s regional peers. Insufficient stakeholder involvement weakens the quality and predictability of policy-making. Despite improvements in the public procurement framework in recent years, systemic factors recurrently hinder fair competition and risk undermining the efficiency of the selection process. Available indicators still point to significant corruption risks. There still has not been enough determined action to prosecute corruption in high-level cases. The weakening of checks and balances, weak accountability and obstacles to access to public information hinder the fight against corruption. ·Employment increased and unemployment decreased in line with the good economic situation but not all groups benefited equally from labour market expansion. The number of women in work or training remains relatively low, also due to the limited availability of childcare. Outward migration and population ageing put pressure on the size of the workforce. A majority of firms in the industry and building sectors report labour shortages as a factor limiting production. The performance of the public employment services, including the targeting and efficiency of policies to help people find or stay in work, could be improved. ·The overall poverty situation has improved markedly in recent years but challenges remain. Income inequality has been increasing, inequalities in access to public services persist and the proportion of people experiencing difficult living conditions is among the highest in the EU and is particularly high among families with several children and the Roma. Poverty and social exclusion are concentrated in certain areas. Key elements of the social safety net have weakened over the past years. The low and shrinking supply of social housing is becoming a challenge against a backdrop of rapidly rising residential property prices. ·Educational outcomes are below the EU average and large differences between schools remain, hindering social mobility. The impact of the socio-economic background of pupils on their educational outcomes is one of the strongest in the EU. Concentration of disadvantaged and Roma children in certain schools has increased in the past decade, particularly in cities. The incidence of early school leaving is above the EU average, and especially high among Roma. The new strategy on vocational education and training aims to attract more students to vocational schools but makes it more difficult for them to switch to the general education path. The shrinking pool of applicants to higher education is likely to limit tertiary educational attainment rates, which holds back innovation and productivity growth. The shortage of teachers is increasingly challenging. ·Although improving, health outcomes remain worse than in most other EU countries, reflecting both unhealthy lifestyles and the limited effectiveness of health care. This is shown by Hungary’s high mortality rates from preventable causes. The public share of health spending in Hungary is considerably lower than the EU average. Consequently, an above-EU average number of Hungarians rely on out-of-pocket expenditure and are increasingly pushed to turn to private care to access health services, with repercussions on social equity as well as population health outcomes. The health system remains excessively reliant on hospitals to provide care services, with insufficient focus on primary care and prevention. Additional investment and reforms are necessary to rationalise the use of resources within the health system, reduce inequities of access and raise quality of care to EU standards. ·Environmental sustainability is a challenge. Hungary is targeting a modest reduction in greenhouse gas emissions from current levels by 2030, mainly through the phasing out of coal-fired power plants. The latest National Energy Strategy aims to increase electricity generation from low-carbon sources to 90% of the total by 2030. In addition to nuclear, Hungary intends to rely more on renewable energy sources, mainly solar energy; by contrast, wind energy does not have any role in the government’s current plans. The low energy efficiency of housing and polluting residential heating methods make air quality worse and both point to large potential environmental and health gains to be achieved by stepping up renovation rates. Greenhouse gas emissions from transport have increased strongly over the last five years and emissions are projected to continue increasing under current policies. The government intends to address transport emissions by promoting electromobility. However, questions remain concerning plans for building charging infrastructure and for promoting other alternative fuels. Identifying investment needs in green technologies and sustainable solutions, and securing adequate funding will be key to delivering on the climate and energy objectives and shaping a new growth model. Water quality and supply remain concerns. Hungary is only at an early stage of moving towards a circular economy and waste management needs to be improved to meet 2020 recycling targets. Institutional issues impede more effective implementation of environmental laws and policies. These environmental challenges require investment and institutional capacity building. The Commission’s proposal for a Just Transition Mechanism under the next multi-annual financial framework for the period 2021-2027, includes a Just Transition Fund, a dedicated Just Transition scheme under InvestEU, and a new public sector loan facility with the EIB. It is designed to ensure that the transition towards EU climate neutrality is fair by helping the most affected regions in Hungary to address the social and economic consequences. Key priorities for support by the Just Transition Fund, set up as part of the Just Transition Mechanism, are identified in Annex D, building on the analysis of the transition challenges outlined in this report. 1. Economic situation and outlook GDP growth The Hungarian economy enjoyed outstanding growth in recent years. GDP has risen on average by 4% each year since 2014 as the economy left behind the legacy of the financial crisis and macroeconomic policies remained supportive. GDP per capita had reached over 70% of the EU average by 2018, the highest level since the transition. Domestic tailwinds also kept the economy resilient to the global slowdown in 2019. These included booming construction investment and the introduction of new models to the production lines of major automotive factories. Graph 1.1:Contributions to real GDP growth Source: European Commission, Winter Forecast 2020

Growth is set to slow in 2020 as the business cycle matures and temporary factors fade. Domestic spare capacity has been absorbed while the external environment remains a drag on exports. Fiscal consolidation is set to reduce public investment while private investment is expected to decelerate, having already reached a high level. Consumption is also projected to slow in line with moderating income growth (see Graph 1.1). Investment activity is at a record level. Construction investment is estimated to have risen to 15% of GDP in 2019, above the pre-crisis average of around 12%, after several years of subdued building activity. Public investment, boosted by the absorption of EU funds and the electoral cycle, exceeded 6% of GDP in 2019, the highest rate in the EU. Commercial real estate investment is responding to pent-up demand, which is evident in historically low vacancy rates. Homebuilding is gradually responding to rising house prices, the improving financial situation of households, and the expansion of housing-related subsidy schemes. Investment in machinery and equipment has also risen substantially, thanks to high capacity utilisation, easy financing conditions and foreign direct investment inflows. Productivity and potential growth Productivity growth has picked up in line with equipment investment, but remains modest. Following the crisis, labour productivity stagnated and the convergence in income per capita was mostly driven by the rising employment rate. The recent rise in investment has also brought labour productivity gains. However, while the investment rate for equipment has already approached its pre-crisis peak, labour productivity gains have remained below the 2000-2007 average (see Graph 1.2). Microeconomic factors, including low innovation activity and the slow reallocation of resources towards more productive firms, continue to hold back productivity growth (see Section 3.4.1). Easy financing conditions and institutional factors may lead to capital misallocation (Cecchetti and Kharroubi, 2015; Restuccia and Rogerson, 2017; see also Section 3.4.2). Graph 1.2:Labour productivity and equipment investment Source: Eurostat, Hungarian Central Statistical Office, European Commission Autumn 2019 Economic Forecast Potential growth is set to slow as the effect of past policy measures fades. In recent years, the economy has benefited from the unfolding effect of earlier measures increasing labour market participation, notably the gradual rise of the effective retirement age. Tax incentives were also created to raise old-age participation. Changes to the tax and benefits system (affecting labour and consumption taxes, unemployment and other benefits) may have also raised participation and long-run GDP, albeit at the cost of higher inequality (Benczúr et al., 2018). Although the government introduced some measures to increase old-age participation, the retirement age is set to stabilise at 65 years from 2022 and the active population is projected to decrease, in line with demographic trends. Labour market and social developments The labour market performs strongly, in line with the good cyclical situation of the economy. Employment and participation continued to rise in 2019. Unemployment, including long-term unemployment, fell to well below pre-crisis levels. Youth unemployment and the share of youth not in employment, education or training have been improving at a slower pace (see Graph 1.3 and Table C.3). However, vacancy data and firms’ perceptions of labour shortages indicate that labour demand has cooled since mid-2019. Graph 1.3:Participation, unemployment and NEET rates Source: Eurostat Structural challenges persist in the labour market. Labour shortages remain significant, especially in sectors employing high-skilled workers. Despite recent improvements, non-employment is higher among the low skilled and people with disabilities (see Section 3.3.1). It is also concentrated geographically, in the less developed regions and in rural areas. While decreasing in size, the Public Works Scheme continues to employ over 2% of the workforce. In the tight labour market, wages have been growing rapidly. According to national accounts data, wages and salaries per employee grew by 8.1% in 2018 and accelerated further in 2019 to an estimated 8.8%. Sizeable minimum wage hikes of 8% in both 2019 and 2020 have also supported wage growth, which is projected to slow gradually in 2020 and 2021 as lower economic growth eases the tightness of the labour market. Employers’ social contribution rates should continue to decrease in line with the six-year wage agreement between the government and social partners. The decreasing tax wedge limits unit labour cost growth, but in recent years it still rose by nearly 4% each year on average, and only a modest slowdown is projected (see Graph 1.4). Graph 1.4:Contributions to unit labour cost growth Source: Eurostat, European Commission Autumn 2019 Economic Forecast The benefits of growth have been unequally distributed. Poverty risks decreased markedly in past years, but material and social deprivation rates remain among the highest in the EU. Poverty and social exclusion show a strong territorial concentration. The adequacy of key elements of the social safety net is weak. Inequality is not high in Hungary compared with the rest of the EU, but it has increased over the last decade (see Section 3.3.2). While median income grew half as much as the regional average between 2008-2018, income growth for the top 5% of the distribution was much higher (see Graph 1.5). As high-income households save a higher share of their income, the changing income distribution could have contributed to the persistently high household saving rate after the crisis. This is corroborated by the recent increase in wealth concentration: financial assets held by the wealthiest 20% of households rose by 36% between 2014-2017, while those of the remaining 80% rose by just 8% (MNB, 2019a). Graph 1.5:Real net disposable income growth between 2008-2018 at different income levels Source: Eurostat Inflation and monetary policy Strong demand and wage growth have fed into inflation. Core inflation has climbed steadily and drove HICP inflation up to 3.4% in 2019. A broader set of measures confirms the build-up of price pressures in the economy. Construction prices were growing by 9.5% in the third quarter of 2019 while the GDP deflator was rising by 4.4% in the same period. In the years ahead, slower economic growth is projected to ease the tightness of the labour market and curtail domestic inflationary pressure. At the same time, imported inflation should remain subdued in line with global commodity and industrial prices. Overall, HICP inflation is projected to remain near the 3% midpoint of the central bank’s target band over the coming years (see Graph 1.6). Graph 1.6:Inflation and unit labour cost Source: Eurostat, European Commission Autumn 2019 Economic Forecast Monetary conditions have remained loose. In 2019, the central bank signalled that downward risks to inflation had become stronger. Through its liquidity operations it lowered interbank rates slightly in the second half of the year. The currency depreciated on a trade-weighted basis by about 4% compared to end-2018. The central bank introduced another round of its subsidised loan scheme for small firms, and a bond-buying programme for larger corporates (see Section 3.2). External position

The current account balance turned slightly negative (-0.8% of GDP in the third quarter of 2019), mostly due to a decreasing trade balance. This level is in line with the current account explained by fundamentals ( ). Export growth slowed down since 2017 along with the demand of trade partners, while strong domestic demand kept import growth high. The increasing absorption of EU funds swelled the capital account balance, thus the net lending of the economy remained positive. In the years ahead, new export capacities and lower domestic demand growth are projected to stabilise the external balance with the current account deficit at less than 1% of GDP. Export market share gains fell behind regional peers since 2016. In 2016-2018, Hungary gained 4% in export market shares, less than the 10.7% average of Czechia, Poland and Slovakia (see Graph 1.7). This difference is mostly due to goods exports, and half of it is explained by the automotive industry. The manufacturing of internal combustion engines plays a particularly important role in Hungary. This segment was hit by the diesel emissions scandal and the slow introduction of new emission test procedures in 2017. Major brands operating in the country also held back production for company-specific reasons. In line with the roll-out of new models in 2019, Hungarian automotive exports started to make up the ground lost in earlier years. Graph 1.7:Export market share growth Source: Source: Eurostat Decreasing cost competitiveness had a measurable effect on trade performance. Strong business investment has supported export growth in recent years through the creation of new production capacity. However, decreasing cost competitiveness is estimated to have led to market share losses in the range of 0.5-1 percentage points per year, because the real effective exchange rate based on manufacturing unit labour cost has appreciated by over 15% since the end of 2015 ( ). The net international investment position continued to improve. It reached -49.2% of GDP by the third quarter of 2019, compared to -113.4% in 2009. This remains more negative than the level implied by fundamentals, estimated at -24% of GDP in 2019. However, the net stock of debt-type instruments has already decreased to near zero. External deleveraging is increasingly driven by high nominal GDP growth, while the contribution of financial flows has diminished in line with the decreasing net lending of the economy. Graph 1.8:Net foreign currency assets by sector Source: Hungarian Central Statistical Office, Magyar Nemzeti Bank The reduction of foreign currency debt has lowered Hungary’s exposure to volatility in international financial markets. Households and corporations had reduced their large net foreign currency debt stocks by 2018, also supported by government measures. Within the corporate sector, exporting firms earn foreign currency revenues to hedge their debt, although exposures remain in construction and commercial real estate. To mitigate these risks, the central bank extended the systemic risk buffer to unhedged foreign currency project loans in autumn 2019. Banks have also started to tighten credit conditions for commercial real estate project loans. The foreign currency denominated debt of the general government also decreased as maturing bonds were mostly refinanced in domestic currency. Its consolidated balance sheet with the central bank now has more foreign currency assets than liabilities (see Graph 1.8). Public finances The general government deficit is projected to shrink, mostly due to spending restraint. Despite favourable economic growth, the headline deficit widened in 2017 and 2018 following procyclical fiscal policies which, in 2018, led the Council to launch a significant deviation procedure for Hungary. Procyclical fiscal loosening seems to have reverted. In its 2019 autumn forecast, the Commission projected the headline deficit to decline from 2.3% of GDP in 2018 to 1.8% of GDP in 2019. The improvement is mostly driven by the moderate increase in current expenditure compared to GDP. The structural deficit is expected to have improved by 0.5% of GDP in 2019, which is below what was recommended by the Council. In 2020, both the headline and the structural deficits are estimated to decrease further, thanks also to the moderating public investment rate. As a result, the debt-to-GDP ratio is expected to keep decreasing. Financial sector The credit cycle is in full swing. Credit demand and banks’ willingness to lend remain strong. Household lending (up by 15.6% year-on-year in December 2019) is also boosted by the new ‘prenatal’ financing scheme introduced in July 2019. However, the stock of private sector debt has not risen relative to GDP. Household indebtedness remains historically low at 18% of GDP in 2019, well below the fundamental threshold of 33% (see Graph 1.9). Consolidated debt of non-financial corporations amounted to 49.7% of GDP in the third quarter of 2019, which is higher than levels implied by fundamentals, but below the prudential threshold. The share of highly indebted enterprises seems to have risen, however (MNB, 2019b). Graph 1.9:Decomposition of debt by sector Source: Eurostat The authorities have introduced multiple interest rates through market segmentation, adding complexity to the financial markets. The central bank and various public institutions operate several preferential programmes, further reducing lending rates mainly for small and medium-sized enterprises (see also Section 3.2). Households can benefit from the new ‘prenatal’ funding scheme, essentially an uncollateralised personal loan with very low interest rates and the possibility of partial or complete debt relief, depending on the birth of additional children (see also Section 3.3.1). At the same time, the government has issued increasing amounts of high-yield retail bonds with limited secondary trading, with the declared aim of encouraging household saving (see Section 3.1.3). Besides their direct fiscal cost, the increasingly complex web of subsidised financial products may also crowd out market-based products and burden the consolidated balance sheet of the government with credit risk. In addition, the authorities repeatedly need to resort to fine-tuning to avoid arbitrage opportunities across market segments. Housing market House prices continued to grow rapidly, causing concerns of overvaluation in Budapest. The national house price index for existing dwellings rose by 7.7% year-on-year in the third quarter of 2019, driven by rising incomes, low interest rates, expanding government subsidies and the anticipated increase in the value-added tax rate for new housing as of 1 January 2020. The central bank’s index shows even higher price increase of 14.7%. The house-price-to-income ratio is at the pre-crisis average for the total economy, while it has reached very high levels for the capital city (see Graph 1.10) ( ). Speculative demand and foreign investors have contributed to the rapid price increases. In 2018, buyers from outside the European Union accounted for 7.4% of transactions in Budapest, a significant jump from a 0.3% share in 2013. While overvaluation appears geographically contained, it may spill over to the rest of the country (Pellényi, 2019). Graph 1.10:House price to income ratio Source: European Commission based on HCSO and MNB Low household indebtedness and moderating buy-to-let demand mitigate the associated risks. Rising house prices do not seem to be fuelled by loose credit conditions. Household debt relative to income is still low and the number of new mortgages even fell in the first half of 2019. In parallel with the launch of the new high-yield retail government bond in mid-2019, the price level of existing dwellings has ceased to grow since the first quarter of the year. Housing construction responds only gradually to robust demand due to capacity constraints. The number of newly built houses has more than doubled in recent years, amounting to around 18,000 units by 2019, but this level is still just half of the pre-crisis average. Capacity shortages in the construction sector have led to cost increases and delays for most residential projects. The expiry of the preferential value-added tax rate for new housing from 2020 and tighter environmental standards from 2021 has also held back the launch of new projects. Industry representatives foresee decreasing building activity from 2021 onwards, once projects currently under way are finalised (MNB, 2019c). Sustainable Development Goals Overall, Hungary performs on average in achieving the Sustainable Development Goals. According to Eurostat’s Sustainable Development Goals (SDG) indicators (see Annex E), Hungary has been making progress in several areas over the past 5 years. Thanks to its favourable economic situation, Hungary performs relatively well in the indicators measuring decent work and economic growth (SDG 8). Indicators on poverty (SDG 1), hunger (SDG 2) and sustainable cities (SDG 11) also improved. However, Hungary continues to lag behind the EU average in the levels of several indicators. Moreover, some deterioration can be observed in indicators of clean energy, inequality and climate-related actions (SDG 7, 10 and 13).

Table 1.1:Key economic and financial indicators - Hungary Source: Eurostat and ECB as of 4-2-2020, where available; European Commission for forecast figures (Winter forecast 2020 for real GDP and HICP, Autumn forecast 2019 otherwise) 2. Progress with country-specific recommendations Hungary has a mixed track record in implementing the Country Specific Recommendations (CSRs). Since the start of the European Semester in 2011, Hungary has made at least ‘some progress’ on 52% of all Country Specific Recommendations. 48% of the recommendations recorded ‘limited’ or ‘no progress’ (see Graph 2.1). Substantial progress has been achieved in the financial sector, for instance in improving the asset quality of the banks and access to finance. Graph 2.1:Overall multiannual implementation of 2011-2019 CSRs to date Source: European Commission Since 2011, the government made progress in strengthening public finances, which, has however stalled over the past years. It has implemented measures including structural reforms to reduce the budgetary deficit below 3% of GDP. As a result, in 2013, the decision on the existence of an excessive deficit was abrogated. However, the structural deficit has substantially deteriorated since 2016, which led the Council to conclude, in 2018 and 2019, that the structural balance deviated significantly from its medium-term budgetary objective. The labour market situation has improved considerably since 2011, supported by the economic upturn as well as measures implemented by the government. In the last nine years, the authorities have taken several measures to reduce the tax burden on labour. The employers’ social contribution was gradually reduced from 27% in 2016 to 17.5% in 2019. The government plans to continue the reduction in the coming years. The tax wedge for families and selected groups was reduced even further. There has been some progress with active labour market policies. For years, the authorities’ main focus was the Public Works Scheme, despite its limited efficiency. By 2019, the number of participants in the scheme had declined significantly on account of improving labour market conditions and some policy measures. Hungary has made little progress on improving its business environment and the proper functioning of the markets. Hungary has received recommendations to improve the business environment every year since the European Semester started. These recommendations cover several fields, including: administrative burden; public procurement; the legislative process; competition; the regulatory environment; corruption and judicial independence. Digitalisation of taxation and public procurement has led to some improvement. The quality of banking sector assets has greatly improved and lending activity has picked up. Between 2013 and 2015, Hungary received yearly recommendations to restore lending to the real economy, to reduce burdens on banks and to improve asset quality. Since then, the banking tax and the level of non-performing loans held by banks has dropped considerably. Hungary has made limited progress in addressing the 2019 country-specific recommendations (see Table 2.1). Limited progress has been made in integrating vulnerable groups into the labour market. Progress has been limited in reducing the complexity of the tax system, in improving health outcomes and in boosting competition in public procurement. Limited progress has been made in focusing investment-related economic policy on research and innovation, low-carbon energy, transport infrastructure, waste management and energy and resource efficiency, taking into account regional disparities. Limited progress has been made towards increasing the participation of disadvantaged groups in inclusive mainstream education. No progress has been made in improving the adequacy of social assistance and unemployment benefits, the anti-corruption framework, prosecutorial efforts, judicial independence, regulatory environment in services or the quality and transparency of decision-making, including the social dialogue. Upon request from a Member State, the Commission can provide tailor-made expertise via the Structural Reform Support Programme to help design and implement growth-enhancing reforms. Since 2018, such support has been provided to Hungary for 10 projects. In 2019, work started on legal analysis that will contribute to reforming the bankruptcy law, on implementing a tax compliance cost survey and improving the performance measurements of the tax authority, as well as on improving the quality and access to primary care services and the quality and relevance of the adult education system. Table 2.1:Assessment of the implementation of 2019 country-specific recommendations (CSRs) (*) Source: European Commission (*) The assessment of CSR 3 does not take into account the contribution of the EU 2021-2027 cohesion policy funds. The regulatory framework underpinning the programming of the 2021-2027 EU cohesion policy funds has not yet been adopted by the co-legislators, pending inter alia an agreement on the multiannual financial framework (MFF). Box 2.1: EU funds and programmes to address structural challenges and to foster growth and competitiveness in Hungary Hungary is one of the countries benefiting most from EU support. In the current Multiannual Financial Framework, EU Cohesion policy funds ( I ) allocated to Hungary amount to €25.4 billion, i.e. around 2.9% of GDP annually. By the end of 2019, €26.7 billion (more than the total amount planned ( II )) was allocated to specific projects, while €10.3 billion was reported as spent ( III ) showing a level of implementation in line with the EU average. EU Cohesion policy funding also significantly supports structural challenges in Hungary. The Cohesion Policy programmes for Hungary have allocated EU Funding of €4.9 billion for smart growth, €9 billion for sustainable growth and sustainable transport and €7.3 billion for inclusive growth. In 2019, following a performance review ( IV ), €1.2 billion have been made available within performing priorities for Hungary. EU Cohesion policy funding is contributing to major transformations of the Hungarian economy. Cohesion policy funds are supporting growth and employment via investments, among others, in research, technological development and innovation, competitiveness of enterprises, sustainable transport, employment and labour mobility. By 2019, investments driven by the European Regional Development Fund and the Cohesion Fund contributed to building or modernising 454 km of roads, both at regional level and in connection with the TEN-T network; more than 140,000 households received broadband access; over 65,000 citizens benefitted from improved wastewater treatment or water supply; support was decided for more than 34,000 enterprises. EU Funds contributed to the reduction of greenhouse gas emissions and developments linked to the digitalisation of public administration procedures ranging from electronic access to the real-estate registry to digitalised processes for tax matters. The European Social Fund supported 605,000 people by Active Labour Market Policies and training initiatives, upheld inclusive education, by training 196,000 pupils and 28,000 teachers and contributed to modernising public administration by delivering competence development trainings for 114,000 public service professionals. Finally, in 2019 was launched a large scale EU funded programme for colon cancer screening, involving over 100,000 people by the end of the year. Agricultural and fisheries funds and other EU programmes also help to addressing investment needs. Hungary benefits from funds coming from the European Agricultural Fund for Rural Development (€4.2 billion), the European Maritime and Fisheries Fund (€50.9 million) and EU programmes such as the Connecting Europe Facility on strategic transport networks (€1,087 million) and Horizon 2020 (€275 million, with beneficiaries including 192 small and medium-sized enterprises for €81 million). EU funding contributes to mobilising important private investment. European Structural and Investment Funds (ESIF) ( V ) supported programmes mobilise additional capital by allocating €2,291 million in the form of loans, guarantees and equity ( VI ). This represents 7.1% of all decided allocations of ESIF. EU Funds invest substantial amounts on actions in line with the Sustainable and Development Goals (SDGs). In Hungary, ESIF supports 13 of the 17 SDGs and up to 93% of the expenditure is contributing to those. 3. Reform priorities 3.1.Public finances and taxation 3.1.1.public expenditures Fiscal policy was procyclical for several years, fuelling growth above the EU average. Fiscal policy in Hungary followed a different trend from that prevailing in the EU. From 2013, the fiscal impulse, as measured by the change of the primary deficit augmented with EU transfers, was higher than the EU average (see Graph 3.1.1). This seems to have contributed to above-average GDP growth in that period. Fiscal policy is expected to have tightened starting from 2019. Graph 3.1.1:Development of the GDP growth and fiscal impulse (differences between Hungary and the EU average), 2012-2018 Source: Eurostat

Public expenditure is highly centralised in Hungary. Primary expenditure fluctuated at around 45% of GDP over the last decades, which is markedly higher than the levels of regional peers. Since 2013, several service delivery responsibilities have been shifted from local to central government level (see Section 3.4.4). As a result, the share of local government in total spending decreased from 25% to 13% in 2017, which is markedly lower than the EU average of 23% (OECD, 2019a). In Hungary, large and centralised expenditure is coupled with low government effectiveness (see Section 3.4.2). This combination is shown to be negatively associated with productivity growth (Fournier and Johansson, 2016). Graph 3.1.2:Change in the structure of the expenditure in Hungary over the last 10 years and the difference, compared with the EU average Source: Eurostat While the size of expenditure was stable over the last decade, its structure changed significantly. Over the last decade spending on social protection, education and healthcare shrunk by 3.4% of GDP, while spending on economic affairs and sport, culture and religion increased by 3.1%. The bulk of the drop in spending on social protection is explained by the cut in social benefits for housing and against social exclusion, albeit from relatively high levels. Currently, public expenditure on social protection is lower by 4.5% of GDP than the EU average because of lower spending on pensions and unemployment benefit. Public spending on healthcare slightly decreased in the last decade and is well below the EU average. Spending on education also decreased, although it is close to the EU average (see Graph 3.1.2). The room created through lower spending on human capital and social benefits has been allocated to improve the state involvement in the economy and on the category of ‘sport, culture and religion’. Hungary spends the most on economic affairs in the EU and this spending increased by 1.6% of GDP in the last decade. This reflects the increased state involvement in the economy and includes, among others, investment grants for businesses, which amounted to 1.7% of GDP in 2016-2018, against an EU average of 0.6% of GDP. Spending on sports, culture and religion also increased substantially from 2010, reaching by far the highest level in the EU (3.5% of GDP in 2017). Spending on sport (1.2% compared with the EU average of 0.3%) is fuelled by the construction of stadia, sports halls and several big-ticket international sporting events. At the same time, the regular sport activity of the Hungarians is one of the lowest in the EU. Overall, inefficiencies are found to be high in spending related to R&D, infrastructure and general public services. In the latter two spending areas, productivity has also deteriorated between 2007 and 2016 (Cepparulo and Mourre, forthcoming). 3.1.2.taxation The tax-to-GDP ratio remains high compared with other countries in the region, with a tax mix geared towards consumption taxes. Despite the recently introduced large tax cuts the tax-to-GDP ratio declined only from 39.5% in 2016 to 37.6% in 2018 (European Commission, 2019a). The tax-rich composition of the GDP and the whitening measures slowed the decrease of the tax-to-GDP ratio. The ratio is in line with the EU average, but above Hungary’s regional peers. The structure of taxation differs from the EU average: Hungary relies more heavily on consumption taxes and less on capital taxes. The level of environmental taxation, which decreased over the last decade, is broadly in line with the EU average (2.3% of GDP in 2018 vs 2.4%) and comes mainly from energy, including transport fuel taxes. Tax exemptions for district heating and fuel use for agriculture, railways and commercial purposes increased over the last decade. There is a reduced VAT rate on district heating. Some subsidies remain in place for the decommissioning and reorganisation of the coal sector (OECD, 2018a). Tax burden on labour is decreasing but the tax wedge for low-income earners remains high. The employers’ social contribution was reduced from 27% in 2016 to 17.5% by 2019 and further cuts are planned in the coming years. The government has recently adopted measures with the aim to provide even more support for families with children. From 2020, mothers with at least four children will be exempt from personal income tax, and the child tax credit keeps expanding, reducing the tax burden of some low-income families. However, the tax wedge for low-income single persons earning half of the average wage was 45% in 2018, 15 percentage points above the EU average (European Commission, 2019a), due also to the flat labour income tax system. A large proportion of single low-income earners are eligible for preferential employer’s social contribution rates under a targeted scheme covering more than 530,000 employees. Even taking into account the preferential rates, their tax wedge remains above the EU average. Large foreign capital stocks, coupled with the absence of withholding taxes on royalty, interest and dividend payments, may point to risks of aggressive tax planning. Inward foreign direct investment (FDI) represented 164% of GDP in 2017. A large share of FDI was held through special purpose entities (SPEs), suggesting a decoupling between financial and real economic activities. More recent data from the central bank suggests the inward stock of FDI decreased significantly in 2018, mainly due to SPEs. However, the proportion of FDI held in SPEs (46%) remained among the largest in the EU in 2018. At the same time, the outgoing income flows such as royalties, interest and dividends towards offshore financial centres were relatively small in 2013-2017. Nevertheless, the Hungarian tax system holds vulnerabilities to aggressive tax planning; notably, the lack of withholding taxes in Hungary on outgoing income to offshore financial centers could provide an escape route for profits to leave the EU without paying their fair share of taxes (Ramboll and Corit, 2016). Hungary is implementing European and internationally agreed initiatives to curb aggressive tax planning. Hungary has implemented many of the provisions of the Anti-Tax Avoidance Directive, such as interest limitation rules and controlled foreign company rules. Other provisions, such as exit tax rules and rules about hybrid mismatches, should be in place from 2020 onwards. Furthermore, Hungary transposed into national law EU Directive, which provides for new transparency rules for intermediaries involved in tax planning. The effectiveness of these new measures in limiting the scope for aggressive tax planning and their impact on corporate income tax revenue in the medium term will need to be assessed. Measures to reduce the size of the shadow economy have produced significant benefits. The value-added tax gap (the revenue loss relative to the total VAT liability) is estimated to have decreased from 21% in 2013 to around 9% in 2018. This trend is expected to continue due to past and current reforms, such as the introduction of online cash registers, the promotion of electronic payments through the payment terminal installation programme and the compulsory electronic invoicing system. The online invoicing system will be extended to all invoices as of July 2020, with the ultimate aim of generating pre-filled VAT declarations for all companies. Tax compliance costs, while decreasing in the past decade, remain among the highest in the EU. E-filing of personal income taxes has increased significantly, from 30% of total personal income tax returns in 2009 to 55.4% in 2017 (European Commission, 2019a). Tax debt, which could be an indication of possible challenges in tax compliance, has decreased by more than 50% since 2014. However, in 2009-2018, medium-sized companies needed 277 hours per year to comply with their main tax requirements, which is significantly above the EU average of 170 hours per year. The time to comply with VAT refunds is also among the highest in the EU (WB-PWC, 2019). Hungary has taken steps to gradually reduce the complexity of its tax system. The government plans to reduce the number of taxes from 60 in 2019 to below 40 by the end of 2020. As of 2020, the simplified tax rate for small companies (KIVA) will decrease to 12%, the simplified entrepreneurial tax (EVA) will be abolished and the four different social security contributions paid by employees will be merged into a unified contribution. Still, a number of special sectoral taxes persist, even though their weight in total tax revenues has been decreasing over the past years. 3.1.3.Public debt development and management Despite the decline in debt-to-GDP ratio, Hungary’s gross financing need as a share of GDP remains the highest in the EU. Since 2012, the credit ratings of the Hungarian long-term debt have improved by 2-3 grades. However, despite these positive developments and the short maturity of debt, Hungary’s implicit interest rate on debt was the highest in the EU every year between 2012 and 2018. Also, as a consequence of relatively high debt and low duration, Hungary’s annual financing need, at 18% of GDP in 2018, was the highest in the EU (European Commission, 2019b). Graph 3.1.3:Implicit interest rate of public debt in the EU Source: Eurostat The public debt ratio has fallen significantly, but remains high for Hungary’s income level. After peaking at 80.8% of GDP in 2011, public debt fell to 70.2% of GDP in 2018. More than half of the debt reduction took place in 2017-2018 thanks mainly to high nominal GDP growth. Temporary factors, however, slowed the process, as the authorities stepped up the absorption of EU funds by pre-financing from the domestic budget. Contingent liabilities remain high in Hungary. At the end of 2018, public guarantees for non-government units stood at 5.2% of GDP, above the 0.5% average of Czechia, Poland and Slovakia. The share of domestic investors in debt financing increased considerably. The share of foreign-currency-denominated debt decreased from above 50% of total debt in 2011 to below 18% in October 2019. Measures to increase the share of domestic investors allowed assets divested by foreign investors to be absorbed. The central bank offered preferential arrangements to domestic banks to buy government bonds. As a result, the share of bonds had increased from around 12% in 2012 to around 25% of banks’ assets by 2019. The government also launched various retail bonds at very attractive rates, including the so-called MÁP+ in June 2019. The new products increased the retail share in total government debt from around 2% in 2010 to 30% in 2019, against an EU average of around 5% in 2018. The increasing reliance on retail investors increases the cost of debt servicing in Hungary, which was already among the highest in the EU. On average, retail bonds offer a yield of 200-400 basis points above the rates available on financial markets, thus increasing the annual debt servicing cost. In addition, financial institutions receive commissions from the debt management agency when selling retail bonds, the costs of which amounted to over 0.1% of GDP in 2018. Furthermore, interest revenue from retail bonds became exempt from tax in 2019, further widening the gap between the available after-tax yield for retail and institutional investors. By contrast, the increasing retail share may temporarily reduce yields on the wholesale market, which may offset some of the costs of the retail bonds. The shift to the retail market also seems to impede the lengthening of borrowing maturities. Retail investors tend to invest shorter term than institutional investors. The share of government debt having a term below one year has doubled over the last decade, reaching 18% in 2018, well above the share of 2.5% of regional peers. The average term to maturity for Hungary also remained quite low, at 4.3 years in 2018. Thus, in spite of improving credit ratings which should allow for better market access, Hungary is moving in the opposite direction of OECD countries, where debt maturity increased to 7.9 years in 2018 (OECD, 2019c). The shorter maturity implies a relatively higher exposure to changes in market interest rates. Due to their design, retail bonds can behave like short term securities in case of market stress. In financial turbulences, bond prices go down, which reduces the incentive to sell, and stops the drop at some point. However, Hungarian retail bonds can be resold to the government at any time with a small discount. This feature does not prevent retail bond owners from selling their bonds and replacing them with bonds from the wholesale market, where the interest increases due to the shock. Experience shows that households can react rapidly to the changing market. In 2019, many households replaced their retail bonds with the new MÁP+, because it offered a higher interest than the earlier issuances.

3.1.4.Debt sustainability analysis and fiscal risks In the short and medium term, Hungary faces low fiscal sustainability risks. As shown by the debt sustainability analysis, as well as the short-term fiscal sustainability indicators S0 and S1 ( ), Hungary does not face significant fiscal risks in the near future (European Commission, 2020 and Annex B). The downward path of general government debt helps explain these results. Nevertheless, there are some indications that could pose potential challenges to the fiscal side of the economy. The low primary balance, high share of short-term debt, high gross financing needs and relatively high yield spreads could deteriorate public finances in the future, especially in case of rapid changes in financial markets’ perceptions. The long-term sustainability of public finances remains a challenge, mainly due to ageing. The country is expected to face an increase in age-related costs of 3.3% of GDP until 2070, driven by public expenditure on pensions (1.9% of GDP) and on healthcare and long-term care expenditure (1.0% of GDP). As a result, the sustainability gap indicator S2 ( ) (2.7% of GDP) indicates medium fiscal sustainability risks for Hungary in the long term (see Annex B). In addition, pension adequacy is creating additional challenges to the long-term sustainability of public finances. There is a growing income gap between new and old pensioners and between pensioners and wage earners, which may lead to additional spending when the gap is corrected (see Box 3.1.1). 3.1.5.Fiscal Framework In the absence of strong automatic stabilisers, discretionary measures need to ensure fiscal stabilisation. With a flat income tax system, low-duration of unemployment benefits, and a strong reliance on less cyclical indirect taxes, built-in stabilisers offer little cushion to the economy if there is a downturn. In order to help macroeconomic stabilisation, fiscal policy must therefore resort to more discretionary measures. Discretionary measures have shown a procyclical bias in recent years. Public investments increased sharply, contributing to capacity constraints in the construction sector and crowding out private investment. The timing of the multi-step social contribution rate cut is contingent on the pace of wage growth, which implies faster tax cuts in a booming economy. Finally, a large component of budgetary reserves, the so-called ‘Country Protection Fund’ (0.8% of GDP in 2020), can only be spent if this does not endanger the deficit target — implying higher expenditure only in good times but lower spending in a downturn. In recent years, the authorities have tended to exhaust the budget at the end of the year leading to the so-called ‘December fever’. In recent years, partly due to the early adoption of the budget, the authorities have tended to underestimate revenues in their budgetary projections and to create high budgetary reserves. Thus, large unexpected revenues have repeatedly appeared relative to budgetary plans. These, together with the reserves, have been spent towards the end of the year, through a series of government decisions and without the need to involve the Parliament, on non-recurrent items such as current and capital transfers (see Graph 3.1.4). Heightened spending at the end of ﬁscal years, with limited parliamentary or public scrutiny, risks resulting in public spending on lower quality projects, with the marginal costs potentially exceeding the marginal beneﬁt. This as also added to procyclical fiscal policies. Graph 3.1.4:Central government cash expenditure Source: Hungarian State Treasury The recent amendments to the domestic numerical fiscal rules brought forward some welcome streamlining and clarifications. In December 2019, the Parliament amended the Hungarian fiscal rules. The so-called debt formula, which has never been applied due to its lax escape clause, was abolished. The discrepancy in the calculation of the public debt ratio between the Maastricht and the domestic definition was also removed. It was replaced by a new provision whereby a number of pre-defined debt-changing factors (e.g. pre-financing of EU funds, statistical reclassifications) need not be taken into account during the within-the-year or ex-post evaluations of compliance with the debt rule. The adopted changes should make the monitoring mandate of the Fiscal Council, which issued its first ex post assessment report of all domestic rules in June 2019, more straightforward. However, the new set-up may still not be conducive to a longer fiscal planning horizon, and the focus is expected to remain narrowly on the annual budget. Box 3.1.1: Increasing inequalities in the pension system Widening income inequalities add to the sustainability challenge of public spending. The correction of such inequalities generally leads to additional expenditure. Since 2016, wages have increased much faster than pensions. According to the law, pensions are rising in line with inflation. In addition, in years when GDP grows faster than 3.5%, pensioners receive a premium linked to economic growth. The premiums amounted to 0.9%, 1.2% and 1.4% of total pension benefits in 2017, 2018 and 2019, respectively. On top of that, the government provided ad hoc compensation to pensioners (food and utility vouchers), amounting to an annual increase of 0.7%, in 2018 and 2019. The premium and the ad hoc compensation are one-off items and are disregarded when setting the next year’s pension. Overall, pensions increased by 2.8%, while wages grew on average by 9.2% annually in the last five years. As a result, the benefit ratio, which is the ratio of average pension over average net wage, declined from 67% in 2015 to 53% in 2019 (see Graph 3.1.4a). Given the rules of pension entitlements, fast wage growth results in a sharp widening of income gaps among pensioners as well. Pension benefits are based on average earnings during a career. To ensure comparable values, annual earnings are revalued by the net average wage growth up to one year before retirement. For example, the pensions set in 2021 include the recent years with fast wage growth, while the pensions set in 2016 do not. As a result, the nominal pension benefits of pensioners who will retire in 2021 will be 35% higher than those of pensioners who retired five years earlier with the same career path. The five year gap was only 1% in 2016. Graph 3.1.4a:1. Income gap between wage earners and pensioners 2. Inequality of income distribution, 65 years+ Source: HSCO, Commission's calculation, Eurostat Inequalities are expected to rise further due to policy measures introduced in past years. While the pension indexation rules caused the largest increase in inequality in the last five years (see the right panel of Graph 3.1.4a), several other policy measures also add to the challenge. In 2011, the flat personal income tax was introduced. The shift decreased the net income of low-income earners, while it increased the net income of high-income earners. The widening income gap is reflected in the pensions, as pension benefits are based on net income. In 2013, Hungary abolished the cap on pension contributions. The elimination of the cap increases budgetary revenues now, as high-income earners pay more contributions. However, it increases future pension expenditure, as the incidence of extra-high pensions will also rise. Both measures increase benefits for high-income pensioners, which increases inequality in the age group above 65. It is also likely to increase the long-term cost of pensions, as high-income groups also tend to live longer. 3.2. Financial sector The banking sector is well capitalised, profitable, liquid and resilient. Banks comfortably meet liquidity and capital adequacy requirements. Their profitability remained strong both in 2018 and in the first half of 2019 but included a significant amount of one-off items, especially provisions write-backs. The ratio of non-performing loans continued to decrease and new loans are deemed healthy, due partly to macro-prudential requirements. The state maintains a strong presence in the financial sector and has difficulty to divest. New lending continued to be strong, supported by high demand and the supply of subsidised loans, which do not seem to be fully justified in the currently very good economic circumstances. Graph 3.2.1:Credit growth Source: European Central Bank (ECB) Table 3.2.1:Financial soundness indicators Source: ECB - CBD2 Consolidated Banking data Loans are still growing strongly. According to European Central Bank (ECB) data, by end-December 2019, the balance sheet of monetary financial institutions in euro had grown by 5.8% year-on-year to €133 billion or 96.8% of GDP. The loan stock of non-financial enterprises grew by 14.1%, while household loans were up by 16.5% (see also Chart 3.2.1). Household loans started especially to pick up in July due mostly to the subsidised loan schemes. Market lending conditions, except for price, have not changed, and the share of fixed-rate loans has been increasing, in line with the central bank’s policies. Banks’ government bond share in the banks’ assets remained the highest in the EU. Non-bank finance is modest and dependent on EU funds. At end-2019, the corporate bond market was only 1.5% of GDP while corporate bank loans where 17% of GDP. The widespread availability of financing questions the need for subsidised loan programmes. The government uses retail bank loans for social policy purposes and the central bank continues with subsidised programmes for businesses. The ‘prenatal’ baby loan introduced in July 2019 attracted a great deal of interest from mostly affluent households and to some extent squeezed out housing loans. In January 2019, the central bank launched the Funding for Growth Scheme “Fix” for small firms with an envelope of HUF 1,000 billion and in July 2019 it started the Bond Funding for Growth Scheme for large corporates with an envelope of HUF 300 billion. The terms of the central bank’s bond purchase programme are much looser than comparable corporate bank loans (e.g. no covenants and collateral, no principal payment till maturity, no pre-determined loan purpose, etc.). Such bonds thus bring more risk to the balance sheets of both the central bank and the commercial banks. Furthermore, after this programme expires, the businesses are expected to continue to face the same impediments when issuing bonds. Given the good health of the banking sector and the abundance of market funding on good terms, the extent of public intervention in the bank credit market appears excessive and may crowd out market lending. The abundance of competing financing schemes also creates incentives and expectations for firms to look for funds with the least strings attached, reducing demand for better-monitored programmes (Kállay, 2015). In addition, banks offer the same or very similar conditions for the subsidised loans, which can hinder competition. The banking sector is stable and would remain resilient under adverse macro developments. Banks maintain adequate financial resilience and sound solvency ratios (see Table 3.2.1). Based on ECB data, their capital increased further by mid-2019 and was above the EU average. According to the central bank, all banks would remain adequately capitalised in a stress scenario. The central bank has prepared resolution plans for all banks and together with the Single Resolution Board is in the process of finalising loss absorption capacity requirements for all banks (minimum requirement for own funds and eligible liabilities). Addressing all impediments to non-performing loan resolution identified in 2014 by the European Bank for Reconstruction and Development would help creditors in a future possible downturn. Bank profits remained strong in 2018 and in the first half of 2019, partly due to one-off items. The average return on equity for all institutions was 14.5% in 2018 and 13.9% in the first half of 2019. The slightly lower profitability in 2019 was due to increased operating costs and lower impairment reversal. The profits still include significant one-off items e.g. write-back of provisions. Interest income improved due to strong credit growth, which also helped net fee income. However, low interest rates and intensifying competition are gradually eroding margins, bringing operating efficiency into focus. Hungarian banks maintain their relative operational inefficiency. Operating costs relative to assets (1.7% in the second quarter of 2019) remain very high compared with the EU average (0.7%), while the cost-to-income ratio (67.3%) is close to the EU average (64.7%). To improve cost efficiency, the central bank has been advocating substantial consolidation in the sector and trimming of the branch networks.

Digitalisation would support efficiency but both banks and consumers need to improve their digital skills. Banks have started engaging with new technologies and are modernising their legacy IT systems. The central bank has established a directorate to foster Fintech developments, issued its Fintech Strategy and runs a regulatory sandbox. The central bank also aims to substantially improve financial literacy, which is a major hurdle for migration of financial services to electronic channels. The instant payment system will start in March 2020. Nevertheless, the close cooperation of all the authorities concerned (e.g. Ministries of Finance and Justice and the central bank) is needed to provide a supportive regulatory environment for financial innovation. Local Fintech and e-money businesses still face hurdles when entering the market and big tech firms have started to expand. Despite efforts, the use of cash in the economy is widespread and even growing. Currency in circulation rose from about 8% of GDP in 2010 to 15.5% of GDP in September 2019. At the same time, the transactions and the volume of bank card payments are also continuously increasing (by 17% and 21% year-on-year, respectively, in the second quarter of 2019). The use of cash is encouraged by, among others, the financial transaction tax (IMF, 2019a) and the large size of the informal economy. Section 3.1 discusses several measures, recently introduced, that are successfully contributing to reduce the size of the informal economy and increase electronic transactions. In November 2019, the banking association proposed further cash reduction measures, e.g. cash limits for businesses, obligatory electronic payments, abolishing the financial transaction tax, changing incentives for cash withdrawals and payments. The Hungarian state still owns a considerable part of the banking system. In line with commitments made to the European Commission, MKB Bank shares were introduced to the stock exchange in June 2019 but no transaction has been recorded so far. Budapest Bank (the eighth largest bank) is still state-owned despite plans to privatise it. The state also maintains minority stakes in Erste Bank Hungary, which it also plans to divest. The central bank will ensure that in the privatisation and consolidation process the ultimate beneficial owners can be identified and are fit and proper. The conflict of interest due to central bank’s majority ownership in the Budapest Stock Exchange, which it supervises, has still not been resolved. 3.3. Labour market, social policies, education and healthcare 3.3.1.LABOUR MARKET The general labour market situation improved in line with the good cyclical economic situation. In 2018, the employment rate for the 20-64 age group reached 74.4%, which is above the EU average of 73.2%. The unemployment rate for the 15-74 age group fell to 3.7%, below the EU average of 6.8%. Youth unemployment (10.2% in 2018) and the rate of youth not in employment, education or training (NEET) (10.7% in 2018) have been improving, although the reduction in both indicators is slowing. Despite favourable trends, not all groups benefited equally from the expansion. The gaps in employment between genders and skills groups remain wide in EU comparison. Labour market outcomes for various vulnerable groups improved, including people with disabilities, the Roma population and women with care responsibilities, but remained well below average outcomes in the Hungarian workforce. Despite its reduction in recent years, the Public Works Scheme continues to employ about 2% of total employment. The NEET rate differs between regions, varying from 6.5% in Budapest to 16.6% in Northern Hungary. Graph 3.3.1:Regional unemployment rate, 2018, % Source: Eurostat Unemployment rates vary to a great extent across regions and skill groups. The difference in unemployment rates between the highest and lowest performing regions was more than threefold in 2018, with a rate of 2.0% in West Transdanubia versus 6.6% in the Northern Great Plain. The unemployment rate of the low-skilled was 9.5% in the second quarter of 2019, compared with 3.0% among the medium-skilled and 1.3% among the tertiary graduates. The duration of unemployment benefits remains one of the shortest in the EU, at a maximum of 3 months, which is significantly shorter than the average time needed to find a job. The average duration of unemployment in 2018 was slightly above 1 year. Labour shortages reached a tipping point in the third quarter of 2019. In the first half of 2019, labour shortages kept rising and the majority of firms in the industry and building sectors reported labour shortages as a factor limiting production. Shortages grew fastest in Hungary within the EU and reached a historical high. They were evident in knowledge-intensive services, education, health and social care. By the end of 2019, in line with the expected slowdown in GDP growth, shortages started to decline. Outward migration puts pressure on the size of the workforce. According to the Labour Force Survey, the number of Hungarian nationals (aged 20-64) living abroad, mostly in Austria, Germany and the United Kingdom, increased by almost 200,000 between 2012-2018 (based on Hárs, 2019 and more recent data for 2018). This outflow was partly offset by the inflow of returning Hungarian nationals and non-EU workers. According to the Hungarian Central Statistical Office, 40,000 foreign workers were employed in Hungary in 2018. Furthermore, a significant share of the 45,000 workers employed by temporary employment agencies were non-EU citizens. Policy responses to demographic challenges focus on a new family support scheme. Government attempts to address the below-replacement fertility rate (1.49 in 2018) include offering preferential loans to credit-worthy married couples, where the women is between the ages of 18 and 40 years. The loan can progressively turn into a grant if children are born or adopted. The programme started in July 2019, so its impact remains to be seen. Early analyses show that the eligible couples are more likely to belong to the higher strata of the income distribution. In the first quarter of the programme, 55% of borrowers belonged to the top income quintile (MNB, 2019b). Graph 3.3.2:Employment rate by age and gender in 2018 Source: Eurostat Limited childcare provision is one of the drivers of the gender employment gap and low fertility. In the past nine years, Hungary has not made progress towards the Sustainable Development Goal 5 (gender equality). The employment rate of women has increased (see annex Annex C). However, the difference between the employment rates of men and women aged 20-64 remained at 15.3 percentage points in 2018, above the EU average of 11.6 pps. Among Roma, the gender employment gap is even larger. The impact of parenthood on women’s labour market activity was at 35.8 pps in 2018, well above the EU average of 26.8 pps. Policies that lower the childcare burden for mothers can increase the fertility rate (Doepke and Kindermann, 2019), and they have a particularly strong impact on the decision to have a first and second child (Hétfa, 2019). However, these tools remain underutilised in Hungary. The share of children under the age of 3 enrolled in childcare increased from 13.8% in 2017 to 16.5% in 2018, but it is still well below the EU average of 35.1% and the Barcelona objective of 33%. The government’s nursery development programme plans to increase the number of crèche places to 70,000 by 2022 from the 48,000 in 2018. Despite increasing employment and wages, some groups of low-skilled workers continue to face challenges in terms of wage adequacy. The employment rate of low-skilled workers increased to over 55% in 2018, which ranks close to the EU average. At the same time, wage dispersion has continued to increase from an already high level. The tax wedge for low incomes has decreased markedly since 2016 but remains above the EU average (see Section 3.1.2). Significant minimum wage increases since 2016 (45%) improved its adequacy, though the level remains low in EU comparison. The public work allowances remained nominally unchanged since 2017 and it now amounts to only around 50% of the minimum wage. In-work poverty increased for workers with temporary contracts and for lone parents (see Graph 3.3.3). Graph 3.3.3:In-work poverty rate in groups Source: Eurostat There is scope to improve the targeting and sustainability of active labour market policies. The Public Works Scheme continues to be the main active labour market policy, both in terms of spending and the number of participants. In 2019, the government launched an Economic Recovery Programme with a pilot project in 50 settlements, aiming to facilitate the transition of workers from public works to the primary labour market. Other active labour market policies suffer from insufficient links to social and health services, and limited outreach. In autumn 2018, the government started to transform the employment departments of the government offices with the aim to better understand local labour demand and improve the matching between jobseekers and vacancies. The performance of the public employment services could be improved. Caseload continues to be high and staff turnover has increased in some counties (also partly due to the recent practice of hiring staff on renewable fixed-term contracts in such counties). Outreach efforts are limited and the public employment services and measures are not tailored to the specific needs of marginalised groups, e.g. the Roma. Social partners’ involvement in policy initiatives and implementation remains limited. The main tripartite body for social dialogue is the Permanent Consultation Forum of the Private Sector and the Government (VKF). Members of the Forum are selected by the Government and do not include some of the traditional trade unions and employers’ organisations. The decisions of VKF are not binding. Even though all topics with labour market relevance might be discussed in the Forum, discussions in recent years were limited to wage-related issues. Sectoral social dialogue bodies are too weak to exert any influence on cross-sectoral decisions. Social partners’ involvement in the preparation and review of policies is mostly limited to general public consultations, with insufficient time allocated for consultation and written reaction. In 2019, among others, the government failed to consult social partners on the tax package for 2019, and the allocation of funding between different types of active labour market policies. The weak institutional framework impacts social partners’ capacity to influence national decision-making. 3.3.2.SOCIAL POLICIES

The overall poverty situation has improved markedly. In 2018, one in five Hungarians was at risk of poverty or social exclusion, for the first time below the EU average. This represented 908,000 people fewer than in 2008 (the national Europe 2020 goal is 450,000). Despite the considerable improvement, the severe material deprivation rate (10.1%) and the material and social deprivation rate (20.1%) were still significantly above the EU averages of 5.9% and 12.8% ( ). While the number of people at risk of poverty or social exclusion decreased, the poverty gap, which measures the depth of poverty, widened from 17% in 2017 to 24% in 2018. Children experience higher deprivation rates compared with the rest of the population. The severe material deprivation rate among children (15.2%) and families with three or more children (22.0%) was among the highest in the EU, well above the EU averages (6.4% and 6.7%). Deprivation, including housing deprivation, is among the reasons for a relatively high share (1.3%) of children under State care, which indicates a need to strengthen prevention ( ). In 2019, close to half of Hungarian Roma (43.4%) faced severe material deprivation, and around four in ten people suffering from it were Roma. Poverty and social exclusion show strong territorial concentration. In the least developed districts, where one in ten Hungarians live, the average income per taxpayer was hardly above the minimum wage. A quarter of the population in South Transdanubia, North Great Plain and North Hungary was at risk of poverty or social exclusion. Residential isolation of Roma is one of the highest in the EU (European Commission, 2019c). In 2019, the government announced a long-term programme, targeting 300 of the least developed municipalities with close to 3% of the population, providing intensive social work and improving access to services. The programme has already started in 31 localities, where 24% of the population is below 14 years of age (compared to 15% nationwide), and 41% live in segregated areas. Income inequality has increased over the past decade and inequalities in access to public services remain high. In 2018, the incomes of the richest 20% of the population were 4.4 times higher than those of the bottom 20%, up from 3.6 times higher in 2008. The ratio remained below the EU average (5.17), but the increase has been one of the highest in the EU. Changes in the tax and benefit system favoured the upper deciles of income distribution which contributed to the increased level of income inequality in Hungary (see Graph 3.3.4) (European Commission, 2019d). Graph 3.3.4:Change in the Gini coefficient due to tax and benefit policies: 2008-2018 Source: European Commission The adequacy of the social safety net weakened over the past decade. Social transfers reduce the poverty rate in Hungary by 48.8%, which is one of the highest in the EU. This is mainly driven by family benefits during parental leave. The poverty-reducing impact of other benefits is low. The minimum income benefit has been unchanged since 2012 and now, at 15% of the minimum wage, it is one of the least adequate in the EU ( ). The public works wage also decreased relative to the minimum wage, from 77% in 2013 to 55% in 2019. Social protection for casual and seasonal workers is limited. Labour shortages strongly affect social services too, affecting service provision and constraining support to families in need. A significant share of the population lives in inadequate housing. In 2018, 7.5% of the population lived in flats that were both overcrowded and suffered from lack of natural light, lack of indoor toilet and bathroom or a leaking roof. This share was among the highest in the EU, well above the EU average (3.9%). It was particularly high among families with three or more children (22.9%, against the EU average of 8.4%) and Roma (European Commission, 2019c). The shortage of affordable rental housing hinders mobility. In the past five years, residential property prices grew fastest in the EU. Property prices grew much faster than incomes (see Graph 1.10 and MNB, 2019c). While there is generous state support for buying a flat, which is accessible mainly for middle-income households, there is no scheme for improving the affordability of renting for the poor and lower-middle income households. The private rental of apartments is weakly regulated and remains largely in the field of the informal economy, which creates risks for both owners and tenants, discourages longer term contracts and deters professional real estate developers (Habitat, 2017; MNB, 2019c). The municipal flats for social rental constituted only 1.1% of the housing stock in 2018. While the above trends restrict the possibility of exiting homelessness, the main policy response was to introduce penalties for homeless people staying in public areas. 3.3.3.EDUCATION AND SKILLS Educational outcomes are below the EU average and large differences remain. By the age of 15, basic skills are significantly below the EU and regional averages (European Commission, 2019e) and have decreased over the last decade. Graph 3.3.5:Underachievement gap in reading by socio-economic status, percentage points Source: OECD, PISA 2018 The impact of pupils’ socio-economic background on their educational outcomes is one of the strongest in the EU (see Graph 3.3.4). Schools are increasingly characterised by the similar socio-economic background of their pupils, with concentrations of disadvantaged pupils in certain schools. The share of schools with over 50% of Roma students increased from around 9% in 2008 to around 14% in 2018. Performance-based selection starting at the age of 10 leads to under-achieving pupils being separated from their high-achieving peers and this possibly contributes to the high share of underachievers in Hungary (25.3% vs an EU average of 21.7%) (European Commission, 2019). The difference in reading performance between pupils enrolled in general education and vocational programmes exceeds 100 score points, corresponding to around three to four years of schooling. The share of disadvantaged students admitted to higher education was very low at 1.4% in 2017, and the share of Roma was only 0.8% (MTA, 2020; KSH, 2018). Reduced autonomy and differences in the regulatory framework for schools based on their status are affecting equity and limit anti-segregation measures. Legislative changes in 2011 restricted schools’ autonomy on teaching content, textbook choice and management of financial and human resources. Licences for textbooks of independent publishers can no longer be extended as of 2019. A 2019 amendment to the School Education Act removed the State’s obligation of obtaining the opinion of the teaching staff, pupils, parents and national minorities on school head appointments. Non-State schools are exempt from some legislative restrictions and in particular have broader room to select their students, thereby limiting the impact and enforceability of desegregation measures. Concentration of disadvantaged and Roma children in schools increased continuously between 2008 and 2018 (MTA, 2020), partly reflecting the demography of the locality in which the school is located. The low effectiveness and equity in the school system are likely to be linked to the low level of curricular autonomy, the lack of socioeconomic diversity within schools and low teacher salaries (European Commission, 2018a, p. 98). In 2018 the early school leaving rate remained above the EU average with no sign of improvement. The rate of early leavers from education and training remained stable at 12.5% in 2018, against the decreasing trend at EU level (EU average at 10.6%). The rate is particularly high among Roma (65.3%) and in the least developed districts (GYERE, 2019). Participation of 17 and 18 year-olds in secondary education dropped sharply between 2011-2016 (from 98% to 85%), after the age of compulsory education was lowered from 18 to 16 in 2012. While studying for a vocational qualification will be supported with a study grant, the new law on vocational education also introduces penalties for parents if their child finishes education without at least a partial qualification. As dropping out concerns mostly schools with a high concentration of disadvantaged learners, this measure may further worsen the situation of disadvantaged families instead of promoting diversity and equity in the school system. The new law on vocational education and training aims to attract more students to both vocational tracks. The law has introduced major changes in the vocational tracks, without an evidence-based analysis of the previous reform of 2015. Vocational grammar schools — the path with a higher element of general education — were renamed ‘technical schools’ (technikum) and will lead to both general secondary education and vocational qualifications; however, there will be no possibility to transfer from these schools with a secondary school leaving certificate (matura) before the final exam in the fifth year. Vocational secondary schools — for less academically inclined pupils — will be renamed ‘vocational schools’ (szakképző iskola) and will no longer lead to matura. The wage disadvantage of vocational secondary school graduates increases by age, indicating the lack of transferability of skills acquired in these schools (Köllő, 2018). Switching between professions or between educational pathways remains difficult by the reduced general education content starting in the first year of vocational schools. As from September 2020, vocational teachers will become employees under the Labour Code and their salaries will no longer be paid according to the unified pay scale and career model of teachers. The shortage of teachers is increasingly challenging. The teacher workforce is ageing: in 2017, 41% of teachers were aged 50 or over, while only 6% were under 30. Dropout rates in initial teacher education are high and fewer than half of the graduates actually enter the profession ( ).The number of new entrants is not sufficient to compensate the number of retirements. The shortage is most significant in disadvantaged areas, for science subjects and foreign languages, and in vocational education and training. Low salaries are one factor: the teacher starting salary is one of the lowest in the EU (Eurydice, 2018; OECD, 2019d). Teachers’ salaries were last corrected in 2013 to close the gap with the national average wage (see Graph 3.3.6). By 2019, the level of teacher’s salary compared to the national average wage dropped again close to the level prevailing before the correction. Phasing out the independent monitoring and evaluation of the trends of teacher shortage and other aspects of education limits the potential of quality policy-making. Graph 3.3.6:Ratio of average teacher's gross salary over national gross wages Source: HCSO, Acts on Budget, Act on public education The growing demand for a highly-skilled workforce is not met by a sufficient number of tertiary graduates. The employment rate of recent tertiary graduates in 2018 was 91.5% (vs an EU average of 85.5%), reflecting strong demand for highly skilled workers. At the same time, the tertiary educational attainment rate among 30-34 year-olds stood at 33.7% in 2018, well below the EU average (40.7%). The dropout rate is around 30% on average and 60% among students who have to self-finance their studies. In parallel, Hungary faces problems retaining its highly educated workforce and is the only country in the EU where the highly educated are more likely to emigrate than the less-qualified groups (Hárs, 2019). The coincidence of a low tertiary attainment rate and a high wage premium for graduates points to a shortage of highly skilled labour (Muraközy and González Vázquez, 2020). 3.3.4.health and long-term care The life expectancy of Hungarians lags behind that of most other Europeans and differs significantly by gender and level of education. At 76 years in 2017, life expectancy of the Hungarian population remained the lowest among Visegrád countries, nearly five years lower than the EU average (80.9 years). Differences in life expectancy by gender and level of educational attainment are significantly larger than those observed across the EU as a whole: on average, women live almost seven years longer than men (EU: 5.2 years), and 30-year old men with a high level of education live 12.5 years longer than those with a low level of education. These stark differences in health outcomes partly reflect the greater concentration of behavioural risk factors, as well as large differences in income and living standards.

High mortality rates from preventable causes reflect the high prevalence of risk factors and the limited effectiveness of public health measures. In 2016, Hungary had one of the highest rates of mortality from preventable causes ( ) in the EU (325.2 vs 161.5 per 100,000 inhabitants in the EU). Against the backdrop of an above-average prevalence of risk factors (i.e. smoking, alcohol consumption, poor nutrition and low physical activity) and low spending on prevention (2.6% of current health spending vs 3.1% in the EU), this indicates substantial scope to strengthen public health interventions in Hungary. Mortality rates from breast and colorectal cancer are also among the highest in the EU, reflecting limited investment in screening and public health programmes. In 2019, health authorities began implementing a national colorectal cancer screening programme supported by EU funds (AEEK, 2019a). Public spending on health is low, and a high reliance on out-of-pocket payments constrains access for poorer households, exacerbating disparities in access to care. Total health spending in Hungary is significantly lower than the EU average, both as a share of GDP (6.9% vs 9.8% in the EU) and in euro per capita terms (€1,468 vs €2,884 in the EU). The public share of health spending is also lower than the EU average, partly reflecting the narrow scope of the benefit package. As a result, out-of-pocket spending accounts for a significantly larger share of total health spending (26.9% vs 15.8% in the EU). Nearly half of out-of-pocket spending is used for medicines, which account for 31% of total health spending. Although the share of spending on medicines is much higher than the EU average (18%), it is lower when measured in euro per capita terms. High levels of out-of-pocket spending, coupled with limited financial protection mechanisms and an above-average incidence of informal payments (ESPN, 2018) deepen inequality of access to healthcare and create significant risks of financial hardship for Hungarian households. There is further scope for rationalising the use of resources and improving the quality of hospital care. Despite improvements in the past decade, discharge rates (20 vs 17 per 1,000 population), average length of stay (9.6 vs 7.9 days) and number of beds (7 vs 5 per 1,000 population) remain consistently above the EU average, pointing to an excessive reliance on hospitals to provide care. The hospital network remains excessively fragmented, hindering efficiency and quality of care. Over the last decade, day surgery for selected procedures has been gradually introduced into the Hungarian health system, yet its take-up has been low relative to other EU countries. Moreover, the current hospital payment system has not been regularly adjusted to reflect the real cost of health services provided. The obsolete hospital payment system, together with low decision-making autonomy at institutional level, has contributed to rising hospital debt which, despite regular bailouts from central government, continues to accumulate, having reached €161.5 million in September 2019, i.e. 0.3% of GDP (State Treasury, 2019). In response, the government appointed budgetary supervisors for the most indebted hospitals. Although authorities started address