EUROPEAN COMMISSION Brussels, 21.11.2018 SWD(2018) 504 final COMMISSION STAFF WORKING DOCUMENT Accompanying the documents Recommendation for a Council decision establishing that no effective action has been taken by Hungary in response to the Council recommendation of 22 June 2018



Recommendation for a Council Recommendation with a view to correcting the significant observed deviation from the adjustment path toward the medium-term budgetary objective in Hungary {COM(2018) 805 final}

{COM(2018) 806 final}



COMMISSION STAFF WORKING DOCUMENT Accompanying the documents Recommendation for a Council decision establishing that no effective action has been taken by Hungary in response to the Council recommendation of 22 June 2018



Recommendation for a Council Recommendation with a view to correcting the significant observed deviation from the adjustment path toward the medium-term budgetary objective in Hungary 1.Introduction Since 2013, Hungary has been subject to the preventive arm of the Stability and Growth Pact, which requires sufficient progress towards the medium-term budgetary objective (MTO). Hungary is also subject to the debt rule as its general government debt remains above 60% of GDP. On 22 June 2018 the Council decided in accordance with Article 121(4) of the Treaty on the Functioning of the European Union ("TFEU") that a significant observed deviation from the MTO occurred in Hungary in 2017. In view of the established significant deviation, the Council issued a recommendation for Hungary to take the necessary measures to ensure that the nominal growth rate of net primary government expenditure does not exceed 2.8% in 2018, corresponding to an annual structural adjustment of 1.0% of GDP. It also recommended Hungary to use any windfall gains for deficit reduction, while budgetary consolidation measures should ensure a lasting improvement in the general government structural balance in a growth-friendly manner. The Council established a deadline of 15 October 2018 for Hungary to report on action taken in response to the recommendation. The Hungarian authorities delivered their report in response to the Council Recommendation (hereafter: "the report") within that deadline. On 18-19 September 2018, the Commission undertook an enhanced surveillance mission in Hungary for the purpose of on-site monitoring under the Article -11(2) of Regulation (EC) No 1466/97. The findings of the enhanced fiscal surveillance were subsequently made public. Section 2 of this document discusses macroeconomic developments and outlook in 2018 and 2019. Section 3 presents the updated budgetary projections for 2018 and 2019. Section 4 assesses compliance with the Council Recommendation of 22 June 2018, while Section 5 proposes an adjustment path for 2019. Section 6 concludes. 2.Macroeconomic developments and outlook 2018-2019 Hungarian economic growth accelerated to 4.7% in the first half of 2018. GDP growth was broad-based, supported by all main domestic demand components and exports. Private consumption benefited from strong real wage growth owing to the tight labour market and administrative wage measures, including the 8% rise in the minimum wage and salary increases in the public sector. Private investment was supported by strong demand and favourable financing conditions, while government fixed capital formation grew dynamically also on the back of increased EU-fund absorption. Table 1: Macroeconomic developments and forecast According to the Commission 2018 autumn forecast, GDP growth in 2018 as a whole is expected at 4.3% (see Table 1). This marks the peak of the domestic business cycle, as growth is set to decelerate to 3.4% in 2019 and to 2.6% in 2020. The expected slowdown is due to the fading effect of administrative wage increases, the moderation of investment dynamics, and the expected weakening of main export markets. Strong demand growth and capacity constraints have begun to raise costs and prices. Unemployment fell to a record low, contributing to strong labour cost growth, which is only partly offset by cuts of employer social contributions. A broad set of indicators point to rising inflationary pressure: the GDP deflator is forecast to rise by 3.7% in 2018, construction costs increased by 9.8% y-o-y in August 2018, while the aggregate house price index rose 12.1% y-o-y in the first quarter of 2018. HICP inflation is set to rise to 3.3% in 2019 on the back of unprocessed food and energy prices, but the underlying momentum will keep inflation at 3% in 2020, after cost shocks fade. The Commission GDP growth forecast for 2018 was revised up since the spring, from 4.0% to 4.3%. The Commission 2018 autumn forecast estimates also a higher GDP deflator in 2018 than in the spring, resulting in a higher nominal path of the economy. The Hungarian Ministry of Finance has not published a comprehensive update of their macroeconomic projections since the 2018 Convergence Programme. Nonetheless, the authorities revised their 2018 real GDP growth forecast marginally upwards, while they increased their nominal path markedly with an elevated GDP deflator as reflected in the 2018 autumn EDP notification. This results in a significant denominator effect on the government revenue and expenditure-to-GDP ratios in the updated budgetary projection for 2018. While the 2018 growth expectation of the Commission is similar to the authorities’ assessment, the 2019 projection remains more conservative compared to the macroeconomic scenario presented in the 2018 Convergence Programme. The Commission forecast expects that capacity constraints exert a stronger effect on prices, which in turn limits real GDP growth. Based on the Commission 2018 autumn forecast and the commonly agreed methodology for calculating the cyclical position of the economy, the positive output gap is projected to widen further in 2018 and to broadly stabilise in 2019. In 2020, GDP growth slows below potential, narrowing the output gap. 3.Fiscal developments and outlook 2018-2019 On 18-19 September 2018 the Commission undertook an enhanced surveillance mission in Hungary for the purpose of on-site monitoring under Article -11(2) of Regulation (EC) No 1466/97. The Commission report on the mission finds that the Hungarian authorities do not plan to act upon the Council Recommendation of 22 June 2018 this year. At the same time, they expressed their commitment to improve the budgetary position as of 2019. The 2019 budget, which was already adopted by the Hungarian Parliament in July 2018, aims to bring down the general government deficit by 0.6% of GDP next year, in line with the plans set out in the 2018 Convergence Programme. However, the Council recommendation does not cover 2019. Updated budgetary projection for 2018 and reported action In their report on action taken , the authorities maintain the general government deficit target from the 2018 Convergence programme of 2.4% of GDP in 2018. The report highlights that the unchanged 2018 deficit target is accompanied by significant changes in the revenue and expenditure sides of the budget. Compared to the 2018 Convergence Programme, the authorities expect substantially higher tax revenues and reduced co-financing costs of EU-funded projects due to a lower-than-initially-planned EU fund absorption. However, the deficit-improvement resulting from these developments (amounting altogether to some 1% of GDP) is projected to be fully absorbed by extra spending, mainly on nationally financed investments and public wages.

The authorities provide a list of discretionary measures they have taken or planned, without providing their estimated impact. Moreover, the list includes only measures with a positive impact on the budget. Table 2 presents those measures listed in the report, which were adopted or announced following the Council recommendation of 22 June 2018 and thus had not been reported yet in the 2018 Convergence Programme. The estimates of the fiscal impact in the Table 2 come from subsequent exchanges with the authorities. Based on these estimates, the reported new discretionary measures have no notable impact on the budget execution in 2018, but rather contribute to the planned deficit reduction in 2019 (i.e. the increase of certain consumption taxes and the rationalisation of staffing public administration starting at the end of 2018). The report also refers to ongoing efforts aimed at enhancing tax collection efficiency, most notably the phasing-in of an online invoicing system for inter-company transactions in 2018. That measure is not included in Table 2 as it was already adopted when the 2018 Convergence Programme was published. The estimated budgetary effect of it has been incorporated in the Commission 2018 autumn forecast (see Table 3). Table 2: Discretionary fiscal measures listed in the report (fiscal impact in % of GDP) Table 3: Discretionary revenue measures included in the Commission 2018 forecast (fiscal impact in % of GDP) Based on the Commission 2018 autumn forecast, which takes into account the above discussed budgetary developments and measures, the general government deficit is projected at 2.4% of GDP in 2018, in line with the authorities’ current target (see Table 4). Compared to the updated budgetary outturn in 2017, the headline deficit is expected to increase by 0.2% of GDP, while the general government deficit excluding the effect of one-offs is set to improve by a similar magnitude. As the positive output gap is projected to continue widening, the Commission projects a deterioration of the structural balance by 0.4% of GDP, from -3.4% in 2017 to -3.8% in 2018. Regarding key factors shaping the 2018 deficit forecast, the fall-out of one-off receipts (i.e. income from land sales) and temporary tax proceeds (i.e. a corporate income tax revenue windfall), which benefited the budget in the previous year, significantly contribute to the increasing headline deficit. Revenues have also been reduced by tax measures, including a 2.5 percentage-point decrease in the employer social contribution rate, the effect of which on the tax-to-GDP ratio is projected to be largely dampened due to a rapid growth of major tax bases. While the revenue outlook improved considerably since the spring, it is set to be matched by extra spending reflecting information provided in the updated budgetary plans of the authorities. Nonetheless, the growth of primary expenditure, excluding increased spending from EU funds, is forecast to slow compared to 2017 and to remain well below the forecast high GDP growth. This projected moderation of spending growth coupled with a continued decline of interest outlays reduces the impact of the above-mentioned deficit-increasing developments. Updated budgetary projection for 2019 According to the Commission 2018 autumn forecast, the headline deficit is expected to decrease to 1.9% of GDP in 2019, just slightly above the budgetary target of 1.8%, declining by around 0.5 percentage points compared to 2018. The impact of fiscal expansion seen since 2017 on the budgetary position is projected to be partly reversed with the structural balance estimated to improve by some 0.5% of GDP to -3.3% of GDP in 2019 (see Table 4). The Commission 2018 autumn forecast incorporates an additional 2 percentage-point cut in social contributions, which is planned by the authorities as of July 2019. The remaining elements of the 2019 tax package are estimated to be broadly revenue-neutral overall (see Table 3). Taking into account the budgeted appropriations, total primary expenditure, excluding spending from EU funds, is expected to increase rather moderately relative to the GDP, which is the key driver of the forecast deficit-reduction. The projected expenditure restraint affects the main spending items at a varying degree. While the public wage bill is foreseen to increase well below inflation and social payments are also set to decline in real terms, spending on government investment is forecast to expand even as a percentage of GDP. Table 4: Composition of the budgetary adjustment Public debt developments In 2017, the general government debt-to-GDP ratio reached 73.3%, decreasing overall by some 7 percentage points from its peak in 2011. The Commission 2018 autumn forecast projects a marked slowdown in debt reduction in 2018 despite the forecast nominal GDP growth above 8%: the debt ratio is expected to decrease only to 72.9% (see Table 5). This stoppage results from a sizeable adverse stock-flow-adjustment effect largely due to the increased pre-financing needs of EU-funded projects and the weakening of the exchange rate. In 2019, the debt ratio is expected to decline faster, falling to 70.3% by the end of the year thanks to the improving budgetary position and the persisting high nominal GDP growth. In 2017, Hungary complied with the debt rule as the government debt-to-GDP ratio remained below the debt-reduction benchmark. A similar conclusion is reached for 2018 and 2019 on the basis of the Commission 2018 autumn forecast. Table 5: Debt developments 4.Compliance with the Council Recommendation for 2018 On 22 June 2018, the Council recommended Hungary to take the necessary measures to ensure that the nominal growth rate of net primary government expenditure does not exceed 2.8% in 2018, corresponding to an annual structural adjustment of 1.0% of GDP. In 2018, based on the Commission 2018 autumn forecast, the growth of government expenditure, net of discretionary revenue measures and one-offs, is projected at 7.0%, well above the recommended reference rate of growth (deviation of 1.6% of GDP, see Table 6). The structural balance is set to deteriorate by 0.4 % of GDP pointing to the opposite direction of the recommended structural improvement of 1.0% GDP (deviation of 1.4% of GDP).