This report on an enhanced surveillance mission to Hungary is transmitted to the Council pursuant to Article -11(4) of Regulation (EC) No 1466/97. As foreseen by Article -11(5) of Regulation (EC) No 1466/97, the provisional findings of that mission have been previously transmitted to Hungarian authorities for comments.

Hungary – Significant Deviation Procedure

Enhanced surveillance mission, 26 September 2019

Report

1. Introduction

Hungary has been under significant deviation procedures since spring 2018. In June 2018 the Council found, in accordance with Article 121(4) of the Treaty, that there had been a significant observed deviation from the medium-term budgetary objective in 2017. The Council issued a recommendation asking Hungary to take the necessary policy measures to address the deviation. In December 2018, the Council concluded that Hungary had taken no effective action and issued a revised recommendation. However, Hungary took no effective action to address the revised recommendation either.

Non-compliance with the preventive arm of the Stability and Growth Pact in 2018 led to the opening of a new significant deviation procedure in June 2019. On 5 June 2019, the Commission issued a warning to Hungary that in 2018 it had again deviated from the adjustment path to its medium-term budgetary objective and proposed to the Council to launch a new significant deviation procedure. The Council asked Hungary to take measures to ensure that the nominal growth rate of net primary government expenditure does not exceed 3.3% in 2019 and 4.7% in 2020, corresponding to an annual structural adjustment of 1.0% of GDP in 2019 and 0.75% of GDP in 2020, with the recommended structural effort in 2020 contingent on compliance with the requested adjustment in 2019.

To this date there is no indication regarding any additional planned corrective action by the authorities in response to the Council Recommendation for 2019. The Commission 2019 spring forecast expected the deficit in 2019 to fall to 1.8% of GDP, from 2.2% of GDP in 2018, in line with the authorities’ target included in the 2019 Convergence Programme. However, the estimated fiscal effort for 2019 pointed to non-compliance with the Council Recommendation. Macroeconomic indicators released for the first half of 2019 show a better-than-expected macroeconomic environment in 2019, with both real and nominal GDP growth exceeding forecasts of the authorities and the Commission. Private consumption benefitted from a strong labour market and the further reduction in employers’ social security contributions. This resulted in favourable budgetary data for 2019, pointing to a fiscal deficit outturn of 1.8% of GDP within reach, i.e. in line with the authorities’ target. However, no additional measures for 2019 were adopted in response to the Council Recommendation.

The 2020 budget, adopted on 12 July 2019, revised the fiscal deficit target to 1% of GDP, down from 1.5% in previous plans. The budget could not be taken into account in the spring assessment as it was adopted after the date of the adoption of the recommendations by the Council. The 2020 deficit target is set in the budget at 1% of GDP, 0.5 pps lower than the target of 1.5% of GDP included in the 2019 Convergence Programme that was published end-April. This lower deficit target is achieved mainly by better-than-previously-forecast tax revenues and lower expenditure due mainly to a cut in investment. At the same time, the 2020 budget also includes the expansionary measures contained in the “Economic Protection Action Plan” that the government adopted on 30 May 2019.

The enhanced surveillance mission by the Commission took place on 26 September 2019. The mission was carried out on the basis of Article 11(2) of Regulation (EC) 1466/97. The mission met the State Secretary for public finances at the Ministry of Finance, Mr. Peter Beno Banai; the executive director responsible for economic sciences and priority matters at the Magyar Nemzeti Bank, Mr. Daniel Palotai; and the President of the Fiscal Council, Mr. Arpad Kovacs. The aim of the mission was to receive detailed information about the fiscal developments in 2019 and about the 2020 budget adopted by the authorities in July 2019, the fiscal actions planned by the authorities, and to point to fiscal risks related to the expected slowing down of economic growth and to encourage compliance with the significant deviation procedure recommendation. This report is based on information obtained until and during the mission.

2. Findings of the mission

The Commission delegation noted that the economy is in good times, with an improvement in the overall fiscal situation (both the general government deficit and debt decreasing). The mission acknowledged the good macroeconomic performance of Hungary in 2018 and in the first half of 2019. Together with the new ambitious 2020 fiscal target, these developments point to an improvement compared to recent years. However, looking ahead, both external and cyclical factors, which have been supporting growth in recent years, are expected to gradually wear off, following the slowdown in some core Western economies and in sectors that play an increasingly important role for the Hungarian economy. The Hungarian authorities agreed that, in a context of decelerating EU growth, it will be challenging for Hungary to maintain growth rates observed in past years, and recognised that the main concern of the Hungarian government was future growth rather than fiscal policy. The mission, finally, recalled the Council Recommendation addressed to Hungary, pointing to the need to seize the opportunity of the positive momentum to secure its fiscal position and reduce further the general government debt.

Despite the better-than-expected macroeconomic and fiscal data so far, the authorities confirmed that they do not plan to revise their deficit target for 2019 nor to reduce further public debt. In 2019, the authorities intend to stick to their initial general government deficit target of 1.8% of GDP as set in the 2019 budget approved in July 2018 and confirmed in the 2019 Convergence Programme. Compared to the originally approved 2019 budget, there are significant extra revenues. At the same time, these are expected to be entirely absorbed by higher expenditure, in particular, by the financial correction on EU funds recently agreed with the Commission related to the fraudulent use of EU funds. The correction in 2019 relates to projects implemented over the period from 2017 to 2019 and is expected to deteriorate the budget balance by 0.3% of GDP. The remaining amount of the financial correction, i.e. about 0.3% of GDP will fall on future years. Also, the take up of the ‘demographic programme’ (following both a higher number of requests and a higher average value of the requested prenatal loan) is expected to be higher than planned. For the latter, the authorities have also increased the estimation for the following year.

The authorities acknowledged recurrent end-of-year spending spurs, however, they pointed out that the size of it decreased last year, taking into account the significant deviation procedure Recommendation. Over the last three years (2016-2018), the authorities have based their budget on systematically cautious fiscal projections and used the fiscal space accumulated over the year on unbudgeted end-year spending. The Hungarian authorities pointed out that these end-year expenditures were non-recurrent spending on investment and that, at end-2018, the government decided not to use the full room for manoeuvre that was available, in line with the significant deviation procedure Recommendation. Without this spending, the fiscal position could have been better.

The 2020 deficit target is more ambitious than previously planned, using good times to accelerate fiscal consolidation as recommended by the Council. The 2020 budget revised the deficit target to 1% of GDP, making it more ambitious than the 1.5% of GDP target indicated in the 2019 Convergence Programme. The authorities stressed the better-than expected macroeconomic scenario, measures to increase tax compliance yet to be defined and expenditure containment as major factors to ensure the reaching of the more ambitious 2020 fiscal target. At the same time, the authorities have maintained 2023 as the year by which they aim to reach a balanced budget in nominal terms. Thus, the revised deficit target for 2020 implies a faster path towards this target. Namely, the authorities target a deficit of 0.7%, 0.4% and 0.0% of GDP for 2021, 2022 and 2023, respectively. In the 2019 Convergence Programme, the deficit trajectory was planned at 1.2% and 0.5% and 0.0% of GDP for the same years. Overall, according to the calculations of the Ministry of Finance, the new headline targets imply, for 2020, a greater improvement in structural terms than the effort recommended by the Council, and the overachievement of the medium-term budgetary objective – set as a structural deficit of 1.0% of GDP – already in 2021.

The authorities expect significantly higher-than-budgeted revenue in 2019, with a positive base effect in 2020. The revenue projection in 2020 is only partly underpinned by discretionary revenue or spending measures, with the only newly specified measure being an increase in excise duties. While the macroeconomic scenario was not revised by the authorities, revenue growth already takes into account the higher revenue expected in 2019, with a significant positive base effect for 2020. However, it remains unclear whether new measures will be introduced and if yes, at which point in time.

The authorities are working on new measures to increase tax compliance and curb the shadow economy, however, without any clear timeline for adoption. New measures will build on the success of similar measures introduced in recent years. The authorities stressed the impressive reduction in the VAT gap which is estimated to have decreased from 21% in 2013 to 9% in 2018, well below the EU average of around 10% (source: European Commission). In particular, the introduction of online invoicing for major companies in July 2018 is estimated to have contributed to the reduction of the VAT gap, and the measure is expected to have some carry-over effect in 2019. For small and medium sized enterprises, in 2013 the authorities introduced two simplified tax schemes (Kata and Kiva) aimed at fighting the shadow economy which have proven quite successful so far in collecting revenues. The authorities are currently working on two fronts: (i) new measures to fight the shadow economy, for example incentives for the use of electronic means of payment; and (ii) simplifying administrative tax obligations for enterprises estimated, among others, to reduce the number of hours spent by companies on tax-reporting obligations (from the actual 277 (Source: Paying taxes 2019, PwC) to below 100 hours) and introducing the pre-filled VAT system, tentatively in 2021. The authorities could not yet reveal the details of the new measures, while on the timeline, in their view a modification of the tax bill could start in autumn 2019, which would make the measures effective in the second half of 2020.

Fiscal consolidation in 2020 is expected to be achieved mostly thanks to a projected contained evolution of expenditure items. The 2020 budget specified expenditure ceilings, with the main area of expenditure cuts being public investment, especially in the construction sector (buildings) which is in a boom phase. The cut of state-funded projects is not expected to have any negative impact on economic growth as there are observed capacity constraints in the supply side of the economy and the expected crowd-in of private investments. As an example of the projects that were cut, the authorities mentioned the Modern City Programme, with a lower-than-expected expenditure in 2020 (from initially estimated HUF 135 bn to HUF 85 bn). At the same time, other expenditure items were expected to be more dynamic, e.g. due to a higher take up of the ‘demographic programme’ and the extension of the housing programme.