EUROPEAN COMMISSION Brussels,7.3.2018 SWD(2018) 215 final COMMISSION STAFF WORKING DOCUMENT Country Report Hungary 2018 Accompanying the document COMMUNICATION FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT, THE COUNCIL, THE EUROPEAN CENTRAL BANK AND THE EUROGROUP 2018 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(2018) 120 final}





Contents Executive summary 1.Economic situation and outlook4 2.Progress with country-specific recommendations 3.Reform priorities 3.1.Public finances and taxation 3.2.Financial sector 3.3.Labour market, education and social policies 3.4. Investment 3.5. Sectoral policies Overview TableAnnex A: Macroeconomic Imbalance Procedure ScoreboardAnnex B: Standard TablesAnnex C: References LIST OF Tables Table 1.1:Key economic and financial indicators - Hungary Table 2.1:Summary table in 2017 CSR assessment Table 3.2.1:Financial soundness indicators, all banks

Table B.1:The Macroeconomic Imbalance Procedure Scoreboard for Hungary (AMR 2018) 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 indicators Table C.6:Green growth LIST OF Graphs Graph 1.1: Contributions to real GDP growth Graph 1.2: Export market shares Graph 1.3: Unit labour cost developments in Hungary Graph 1.4: Contribution to inflation Graph 1.5: Activity, employment and unemployment Graph 1.6: Labour as a limiting factor in industry Graph 1.7: Breakdown of Credit Flows by sector Graph 1.8: Net international investment position Graph 1.9: GDP per capita based on purchasing power parity (% of EU average) 5 Graph 1.10: Development of potential GDP growth Graph 2.1: Hungary - Level of implementation today of 2011 - 2017 CSRs

Graph 3.1.1: The evolution of tax wedge for a single worker earning 67% of average wage Graph 3.1.2: Evolution of public expenditure as share of GDP Graph 3.1.3: Composition of general government spending in the average of 2013-2015 Graph 3.1.4: Gross government debt ratio: the baseline scenario and alternative trajectories Graph 3.2.1: Development of the NPL ratios Graph 3.2.2: Banking system assets to GDP Graph 3.2.3: Corporate and household loans growth rate (y-o-y) Graph 3.3.1: Change in real productivity, real GDP per capita and real wages (2008-2016) Graph 3.3.2: Wage premium of educational attainment as compared to low education Graph 3.3.3: Main poverty indicators since 2005 22 Graph 3.3.4: Hospitalisations for ambulatory care-sensitive conditions (per 100.000 population) Graph 3.4.1: Private and public investment Graph 3.4.2: Worldwide Governance indicator score: Hungary and regional peers (EU average=100) Graph 3.4.3: Risk scores related to low competition and transparency in Hungarian public procurement - corruption risk indicators Graph 3.4.4: Share of tenders without prior publication and with only a single bidder above EU threshold Graph 3.5.1: The proportion of SMEs introducing innovations LIST OF Boxes Box 1.1: Steep wage growth: realignment or overshoot? Box 2.1: Tangible results delivered through EU support to structural change in Hungary

Box 3.2.3: Housing prices in Hungary Box 3.3. 1: Monitoring performance in light of the European Pillar of Social Rights Box 3.4.5: Investment challenges and reforms in Hungary Box 3.4.6: Interfirm productivity differences and the duality of the economy Box 3.5.7: Policy Highlights Executive summary Hungary's steady economic recovery offers a window of opportunity to ensure sustainable growth in the coming decade.() The country's financial vulnerabilities seen in the aftermath of the crisis have been markedly reduced and the economy has been staging a steady recovery. Real GDP surpassed its pre-crisis peak in 2014, whereas domestic demand and investment reached similar levels by 2017. The growth potential has been gradually recovering, albeit it still remains moderate for a catching-up economy. Reflecting also the costs of economic adjustment, the income convergence of the country has been relatively slow lagging behind regional peers. The main challenge now is to bolster economic convergence by well-designed structural reforms, while maintaining a balanced growth path. After a temporary lull, the Hungarian economy grew strongly in 2017. GDP is estimated to have grown above potential helped by a supportive external environment and accommodative domestic policies. Household consumption was boosted by double-digit wage growth. Investment picked up strongly also due to the resumption of EU fund absorption. Corporate investment by large firms gained momentum, while household investment increased sharply albeit from a low level. Healthy export growth mirrored global developments, but the contribution of net exports to growth turned negative as imports grew even faster. Inflation increased and approached the central bank's target. In 2018, growth is projected to remain strong as supporting factors are expected to prevail. Employment reached record-highs. While the economic upturn is the main driving force, policy measures also helped to improve the labour market situation. Cross-border labour migration and adverse demographic trends however reduced labour supply, particularly among skilled workers. The unemployment rate thus fell to its lowest level on record in 2017, and in certain segments labour shortages emerged. Bank lending picked up. New lending grew strongly, while banks rapidly reduced the stock of non-performing loans in 2017. As a result, credit stock grew at a rate close to nominal GDP growth and asset quality improved significantly. The economic recovery and central bank measures facilitated the process. Banks comfortably met capital requirements and returned to profitability. The fiscal stance is loosening. Despite buoyant domestic demand, the headline deficit is forecast to increase from 1.9 % of GDP in 2016 to around 2.5 % in 2018. Hence, the structural fiscal balance is projected to deteriorate well below the country's medium-term objective. This results mainly from significant cuts in social contributions and taxes. The government debt-to-GDP ratio has been decreasing gradually and is expected to decline further in the next two years thanks to high nominal GDP growth. However, in the absence of future fiscal adjustment, this positive trend is at risk in the medium term Albeit contained at this stage, risks to a balanced growth path may start to emerge. High capacity utilisation suggests that the economy is now moving above potential. Particularly, labour supply may soon reach its limits, adding to the already considerable wage pressure. House prices have been increasing rapidly since 2014. Nevertheless, domestic demand in real terms only reached the pre-crisis level in 2017, and real house prices stayed below pre-crisis levels. Moreover, the current account remained in surplus. However, the pressure on consumer prices may accumulate if consumption growth accelerates further on the back of fast wage growth, falling precautionary savings and strong lending. Hungary made limited progress in addressing the 2017 country-specific recommendations. Whereas some progress was made in reducing the tax wedge for low-income earners, less was achieved in reducing the complexity of the tax system. Some progress was made in strengthening transparency and competition in public procurement, but progress was limited in strengthening the anti-corruption framework. Limited progress was made in improving the regulatory environment in services. There was some progress in better targeting the public work scheme and reinforcing other active labour market policies. The progress was limited in increasing the participation of disadvantaged groups, in particular Roma, in inclusive mainstream education and in improving the adequacy and coverage of social assistance and unemployment benefits. Regarding the progress on reaching the national targets under the Europe 2020 Strategy, Hungary is performing well in reducing greenhouse gas emissions, increasing renewable energy, tertiary education and the employment rate; while more effort is needed to increase R&D intensity and reduce early school leaving and poverty. Hungary performs well on a number of indicators of the Social Scoreboard supporting the European Pillar of Social Rights, but challenges remain. The gender employment gap merits attention, together with the low share of children under the age of 3 enrolled in formal childcare. The share of early school leavers increased further from an already high level. Employment outcomes have been buoyed by the recovery. Income inequality is relatively low and the effectiveness of social transfers in reducing poverty remains comparatively high despite some deterioration recently. Key structural issues analysed in this report, which point to particular challenges for Hungary's economy, are the following: ·Several measures have been implemented to improve the tax system, but some problems remain. The country's high tax burden is set to moderate due to sizable tax cuts. Moreover, the lowering of social contributions helps to ease the impact of wage increases on labour costs. Nevertheless, without offsetting measures, these tax cuts pose medium-term fiscal risks. While decreasing, the tax wedge on labour, especially for certain low-income groups, is still high in EU comparison. The complexity of the tax system, coupled with the continued presence of sector-specific taxes, remains a weakness. Administrative burdens of tax collection are still significant, but considerable efforts have been made to address this. Some indicators suggest that Hungary's tax rules may be used by multinationals in aggressive tax planning structures. It is shown by the large capital flows as a share of GDP through special purpose entities, combined with the absence of withholding taxes. ·Hungary faces a pronounced productivity challenge. Productivity growth has been slow for a decade now compared to peer countries. Although potential growth estimates show some recovery, the challenge is becoming more pressing as labour reserves diminish. There are wide and persistent productivity differences between export-oriented, mainly foreign-owned companies and smaller domestic firms, with limited positive spill-overs from the high-productivity segment. The propensity of SMEs to innovate is low and Hungary remains a moderate user of digital technologies. Regulatory barriers in services and retail trade and unpredictability of regulation hamper the efficient reallocation of resources. Institutional weaknesses and human capital inadequacies also constrain productivity growth. ·Weaknesses in institutional soundness and governance could weigh on the country's economic convergence. Limited transparency and quality of policy making is a source of uncertainty for investors. There are deficits in evidence-based policy formulation and stakeholder engagement. Social dialogue structures and processes remain underdeveloped. Hungary performs weakly on the accessibility and quality of public information. Challenges concerning the functioning of the justice system require close monitoring. Available indicators point to notable corruption risks, and there are gaps in the anti-corruption framework. Important measures were taken regarding public procurement, but there remains scope to further improve transparency and competition in tendering processes.

·The education and healthcare systems reveal shortcomings in fostering the development of human capital. Education outcomes in basic skills are significantly below the EU average. The impact of socioeconomic background on education outcomes is among the highest in the EU. Disadvantaged students, in particular Roma, remain concentrated in certain schools. The health system is faced with high risks from unhealthy lifestyles, uneven quality of care and disparities in access. While showing improvements, health outcomes lag behind most other EU countries reflecting also the limited effectiveness of healthcare provision. Despite reform efforts, the setup of service delivery remains strongly hospital centred, with weaknesses in primary care and care coordination of chronic disease patients. ·Employment policies face the challenge of mobilising labour reserves fast enough to meet strong labour demand. While the public work scheme still remains the main active labour market policy, it has had limited success in bringing participants back to the labour market. Nevertheless the number of its participants started to diminish thanks to the strengthened recovery. The government is taking further steps to facilitate this process, while other active labour market policies are gradually expanding. However, an evidenced-based system that would help jobseekers to receive services tailored to their particular needs is not yet in place. The high gender employment gap points to untapped labour reserves. To utilize this reserve, measures were taken to improve the availability of childcare facilities. The low employment rate of Roma remains an important challenge. ·Overall, the situation regarding poverty improved notably, but vulnerable groups continue to face high risk of poverty. While the share of population at risk of poverty and social exclusion is falling, it is still above the EU average. Children and the Roma remain much more exposed to the risk of poverty than the rest of the population. Changes in the tax and benefit system contributed to rising income inequality. There has been a clear shift from social benefits towards work-related family supports and in-kind benefits, which are not sufficiently targeted to the poor. At the same time, the adequacy of social assistance and unemployment benefits declined. While home-ownership subsidies expanded, there is no improvement in social housing. 1. Economic situation and outlook GDP growth Following a temporary lull in 2016, growth picked up in 2017 due to a supportive external environment. GDP is expected to grow above potential on the back of the resumption of EU-funded investment, fiscal stimulus, negative real interest rates and the strong recovery of the global economy. As a result, real GDP is expected to have increased by 3.8 % year-on-year in 2017 (Graph 1.1). Economic growth continued to be primarily driven by domestic demand. Gross fixed capital formation is expected to have grown above 20 % in 2017 and household consumption was also picking up. Trade flows accelerated in 2017, while import growth outpaced export growth. As a result, net exports contributed negatively to real GDP growth in 2017. Graph 1.1:Contributions to real GDP growth Source: DG ECFIN, Autumn 2017 Economic Forecast Strong growth is set to continue. Real GDP growth is projected to increase by 3.7 % in 2018, but to slow to 3.1 % in 2019 as capacity constraints emerge on the back of a gradually widening positive output gap. Household consumption and investment are projected to expand strongly in 2018, boosted by government-initiated and market-driven wage increases, and supported by a strong recovery in bank lending. Corporate and public investments are forecast to continue to grow by double digits as EU-funded projects are implemented. At the same time, strong domestic demand is set to result in rapid import growth and thus the growth contribution of net exports is expected to remain negative. In 2019, economic growth is projected to slow as a result of a build-up in capacity constraints, slowing growth of real disposable income and moderating trade as economic recovery matures in the EU. Graph 1.2:Export market shares Source: Eurostat Hungary's export market share continues to recover. The aftermath of the financial crisis resulted in a cumulative loss for the country's export market share, which totalled 24 %. Since 2013, Hungary has increased its export market share and by the end of 2016 it regained one third of the previous losses (Graph 1.2). New export capacities and improved cost competitiveness supported the recovery. Additional export capacities are in the pipeline, in particular in the automotive sector, which is expected to facilitate improvements in export performance. However, increasing unit labour costs pose a risk in the years ahead. Hungary's unit labour costs increased further in 2017. The deterioration in cost competitiveness started in 2016, when the increase in labour costs was coupled with relatively low GDP growth. However, following the crisis, cost competitiveness steadily improved, which may provide some room for increasing labour costs. In 2017, nominal unit labour costs grew by 4.9 %, which was 4 pps. above the EU average. This increase was mainly driven by wage growth. Productivity gains were only about half as strong as real compensation gains by employees. Inflation also contributed to the nominal unit labour costs increases (Graph 1.3). Looking ahead, real wage growth is set to slow down. Real unit labour costs are therefore expected to stabilise by 2019. Graph 1.3:Unit labour cost developments in Hungary Source: Eurostat Inflation and monetary policy Inflation picked up in 2017 and is projected to accelerate further as domestic price pressures increase. Headline inflation remained muted between 2014 and 2016 as falling energy prices fully offset limited inflation in services and food. However, core inflation remained stable at around 1.3 %. Inflation is forecast to accelerate towards the central bank’s target of 3.0 %. Price growth is expected to be broad based, as energy prices rise further and prices of services accelerate on the back of strong wage growth (Graph 1.4). Price pressure may re-emerge against the backdrop of pro-cyclical fiscal and monetary loosening. Gross wages grew by more than 12 % in 2017 and are expected to growth rapidly in 2018 as well, affected also by minimum wage hikes. Asset prices are rising, which also improves the wealth of households. All these would point to strong consumption. However, in 2017 consumption lagged behind wage developments, probably as a result of cautious behaviour rooted in the crisis. Moreover, wages are increasing from a historically low level (see Box 1.1), which may explain the gradual pick-up in consumption. There is a risk that inflation will accelerate as households' confidence raises and the previously delayed consumption of durable goods recovers. In addition, negative real interest rates may induce an increased take up of loans. These risks are expected to be exacerbated by fiscal loosening. Graph 1.4:Contribution to inflation Source: European Commission calculations Monetary policy remains accommodative. The base rate has been unchanged at 0.9 % since May 2016. Moreover, the volume of the deposit facility was gradually limited to HUF 75 billion by the end 2017. This gave an impetus to banks to lend, or as an alternative buy domestic sovereign debt, which now represents a large share of their assets. In recent years unconventional policy tools played a key role to support monetary loosening. As a result of global developments and measures of the central bank, long-term interest rates declined to a historic low, below 2 % by the end 2017. Labour market The Hungarian labour market performance continued to improve, while the market became increasingly tight. Employment continued to expand to hit new all-time-highs in 2017, and unemployment rate fell close to 4 % in 2017 (Graph 1.5). These developments were due to structural factors (the increasing education level, past reforms closing early retirement pathways), as well as to improving cyclical position of the economy. Participation in the public works scheme (PWS) declined, yet the scheme still employed about 4% of the labour force in 2017 (see Section 3.3). Graph 1.5:Activity, employment and unemployment Source: Hungarian Central Statistical Office (HCSO)

Graph 1.6:Labour as a limiting factor in industry Source: European Commission Labour shortages generate strong wage growth and limit the prospects for further employment growth. The economic sentiment indicator shows that the Hungarian labour market is far tighter than in its regional peers (Graph 1.6). Cross-border labour migration and adverse demographic developments withdraw a sizeable amount of well qualified workforce from the labour market, which has contributed to labour shortages. Outward labour migration started to intensify after 2010 (Hárs, 2016). Between 2010 and 2014 the net effect of cross-border migration amounted to a loss of around 200 000 people. Labour migrants tend to be more educated than the average population in both the home and destination countries (SEEMIG, 2014). Demographic developments reduced active population further by 100 000 during the same period. Scarce labour drives up wages, while higher wages may ease the tightness of the labour market by discouraging emigration. Social developments The economic recovery and higher wages have contributed to the overall improvement of the poverty situation. The share of population at risk of poverty or social exclusion is decreasing, returning to pre-crisis level, but remains above the EU average. This positive development is mainly driven by falling severe material deprivation and decrease of jobless households, thanks to increasing employment level and higher labour related income of households. However, the incidence of poverty decreased to lesser extent compared to the improvement of the labour market situation, particularly for children. Income inequalities grew at the beginning of the decade but have remained below the EU average. In 2010, the richest 20 % of households had income that was 3.4 times higher than that of the poorest 20 %. By 2016 this ratio had increased to 4.3. Over the same period, the income of households has not grown as fast as GDP, raising questions about the inclusiveness of growth. Changes to the tax and benefits system also contributed to rising income inequality (see Section 3.3). Public finances Accelerating economic growth is also supported by fiscal loosening. After hitting a historic low of 1.9 % of GDP in 2016, the headline deficit is forecast to increase to 2.1 % of GDP in 2017 and then further to 2.6 % in 2018 before receding to 2.3 % in 2019. These developments mainly reflect substantial tax cuts (see Section 3.1) and partly also spending increases. The expansionary fiscal stance is expected to result in a sharp deterioration in the estimated structural balance, reaching -3½ % of GDP in 2018 and 2019, well below the country's medium-term objective of -1.5 % of GDP. The gradual decline of public debt is expected to continue in 2017-2019. It is supported by the forecast for high nominal GDP growth, while the pre-financing needs of EU funds result in a temporary debt-increasing effect. The government debt-to-GDP ratio is projected to decrease from 73.9 % in 2016 to below 70 % by the end of 2019. However, the deterioration of the structural balance poses a risk to the debt-reduction path in the medium term (see Section 3.1) Financial sector Graph 1.7:Breakdown of Credit Flows by sector Source: Eurostat Private sector debt ratios continued to contract on account of cross-border loans of corporations. Private debt was reduced to around 78 % of GDP in 2016 from its peak of 117 % of GDP in 2009. The credit flows turned positive for households in 2016 as the new government housing support scheme and rising property prices started to spur household borrowing (Graph 1.7). The growth in credit to non-financial corporations contracted. The contraction was due to inter-company loans and loans from foreign financial institutions, while the credit stock in domestic financial institutions increased. Overall, credit growth in 2016 remained limited by banks’ cautious lending strategies. However, the situation improved markedly in 2017. The year-on-year growth in credit to non-financial corporations provided by domestic institutions outpaced the nominal GDP growth in Q3 2017 (see Section 3.2). External position Graph 1.8:Net international investment position Source: Eurostat External balances continued to improve. Negative net international investment position (NIIP) is expected to have improved to around 58 % in 2017 from its peak of 115 % in 2009, although it remains above the prudential and fundamentally explained thresholds for NIIP ( ) (Graph 1.8). Net external debt declined from above 78 % of GDP in 2009 to below 10 % of GDP in 2016, acting as a mitigating factor in external sustainability risks. The economy was rebalanced by maintaining high current and capital account surpluses. EU funds kept the capital account in a sizeable surplus, while the private investment rate and consumption of durable goods were below their historical averages. Hungary’s strong net lending position is expected to sustain as supporting factors remains in place. However, the surplus is expected to fall slightly in 2018 and 2019 as domestic demand will pick up. Real convergence and potential growth The convergence towards the average income level in the EU continued, albeit at a relatively slow pace. Hungary's GDP per capita in purchasing power parity terms increased from around half of the EU average in 1995 to two thirds by 2016 (Graph 1.9). However, the country's real convergence has been lagging behind most of its regional peers, even after taking into account differences in starting positions. In 1995, Hungary had the third highest GDP per capita among the EU countries in Central and Eastern Europe, and was 15 % above their average. By the end of this 21-year period, the country had fallen to the seventh place with a level somewhat below the regional average. While the post-crisis period saw a general deceleration in real convergence in the region, Hungary's catching-up had slowed down noticeably already after 2003. Moreover, wide internal disparities remained with an increasing gap between the most and least developed regions in Hungary. Graph 1.9:GDP per capita based on purchasing power parity (% of EU average) Source: Eurostat Hungary's growth potential is picking up, but productivity growth still remains moderate for a sustained improvement. Following a sharp fall after 2008, the recovery of the country's potential GDP growth is expected to accelerate, rising to an average of 2.8 % in 2017-2019 (Graph 1.10). It is already close to the average of regional peers, albeit still remains some 0.5 pps. below the level seen before the crisis. After several years showing a negligible growth contribution, total factor productivity (reflecting the quality and efficient utilisation of resources) has also started to recover. However, the estimated productivity growth still remains moderate both historically and in regional comparison. As labour's contribution to potential growth is expected to diminish in the future, the estimated improvement in growth potential may not persist in the medium term unless total factor productivity is enhanced further. Based on the forecast trends, potential growth is projected to drop to below [xx]% again after 2019. (The productivity challenge is also discussed in Boxes 1.1 and 3.4.2, while some key constraining factors are highlighted in Sections 3.3, 3.4. and 3.5)

Graph 1.10:Development of potential GDP growth Source: European Commission calculations, Box 1.1: Steep wage growth: realignment or overshoot? In 2017-2018, Hungary is expected to experience sharp increases in nominal wages, due to the tight labour market and further propelled by significant minimum wage hikes. From a historical perspective, the wage share (i.e. the ratio of labour cost per employee to the gross value added per total employment) in the total economy declined during the post-crisis years and fell below the long-term average. This shows that wages were lagging behind productivity developments over this period. In 2016, the wage share started to increase sharply and is expected to rise further, reaching its historical average in 2018. It is then expected to stabilise as wage dynamics slow and GDP growth remains strong. Large firms and foreign-owned firms are likely able to cope well with increasing labour costs as the wage share in manufacturing, where many such firms operate, is much lower than in the total economy. A study (Palócz, 2016) found that foreign companies are three times more productive than domestic firms, which makes them more resilient against some loss in price competitiveness. Firms may also be able to react to increasing wage costs by dislocating part or all of their production. However, wage levels in Hungary are still low among peer countries and they also enjoy fast wage growth. Less productive firms, in particular SMEs, face challenges to be able to cope with rapid wage rises. The Hungarian wage share in the total economy is higher than in the regional peers. This suggests that there is little room to increase labour costs in SMEs. SMEs could potentially adapt to wage increases with the help of preferential and simplified tax schemes for SMEs or informal economy practices. In addition, the rate of social contribution was cut by 7.5 pps. in two years, which mitigates the effect of increasing wages. In the past, part of salaries may have been paid informally, so the effective increase in labour costs could have been smaller than indicated by wage statistics. In labour-intensive service sectors firms may also pass on rising wage costs in output prices. Inflation in such services jumped to above 4% in 2017. Overall, the sharp wage increases in 2017-2018 can be considered realignment rather than an overshoot. However, higher labour costs affect firms differently. In manufacturing there may be more room to increase wages. Due to the tight labour market, there is a risk of a faster wage rise than forecast, which would lead to a further loss in cost competitiveness and price pressure. Table 1.1:Key economic and financial indicators - Hungary Source: Eurostat and ECB as of 30 Jan 2018, where available; European Commission for forecast figures (Winter forecast 2018 for real GDP and HICP, Autumn forecast 2017 otherwise) 2. Progress with country-specific recommendations Progress with the implementation of the recommendations addressed to Hungary in 2017 has to be seen in a longer term perspective since the introduction of the European Semester in 2011. Looking at the multi-annual assessment of the implementation of the CSRs since these were first adopted, 64 % of all the CSRs addressed to Hungary have recorded at least 'some progress'. 36 % of these CSRs recorded 'limited' or 'no progress' (see Figure 2.1). Substantial progress has been achieved in fiscal policy as the country exited from the excessive deficit procedure and the debt ratio has been put on a firm downward path. Similarly, substantial progress has been made in the financial sector, for instance improving the asset quality of the banks and access to finance. Graph 2.1:Hungary - Level of implementation today of 2011 - 2017 CSRs Source: European Commission Since 2011 the government has achieved considerable progress in strengthening public finances. The government implemented measures including structural reforms to decrease budgetary deficit below 3 % of GDP in a durable manner. As a result, in 2013, the decision on the existence of an excessive deficit was abrogated. However, recently, structural deficit deteriorated. The labour market situation has improved considerably since 2011 supported by the measures implemented by the government. Recommendations on labour taxation, tax compliance, active labour market policies, education and social assistance have been adopted repeatedly since the launch of the European semester. In the last 7 years the authorities have implemented several measures to reduce tax burden on labour. The tax wedge has decreased, especially for families and selected groups. However, it remains high, in particular for low income earners. Some progress can be observed regarding active labour market policies. For years, the authorities' main focus was the public works scheme, despite its limited efficiency. Recently, the number of public workers started to decline reflecting improving labour market conditions. Efforts of the government to increase tax compliance yielded significant results, in particular due to the introduction of the online cash registers. Hungary has received recommendations to improve the business environment every year since the European Semester started. Recommendations cover several fields including administrative burdens; public procurement; the legislative process; competition; regulatory environment and corruption. While the complex tax system and high compliance cost remains a challenge for firms, several promising measures were developed building on digitalisation. The authorities implemented a number of measures to strengthen transparency and competition in public procurement. Hungary adopted a new legislation and introduced the e-procurement system which is a big step towards further increasing transparency and competition in public procurement. The quality of the banking sector assets has greatly improved and lending activity has picked up recently. Between 2013 and 2015 Hungary received yearly recommendations to take measures to restore lending to the real economy to reduce burdens on banks and improve asset quality. Since then banking tax has been reduced significantly and the level of non-performing loans held by banks has dropped considerably. Following the 2016 country report and the in-depth review, Hungary was found to no longer experience macroeconomic imbalances. Hungary was assessed to be on a balanced, albeit still relatively moderate growth path, while the public debt ratio declined since the beginning of the decade. The indicators of net international investment position had rapidly improved. Hungary has made limited progress in addressing the 2017 country-specific recommendations (see table 2.1). Whereas, some progress has been made in reducing the tax wedge for low-income earners, there has been less so in reducing the complexity of the tax system. Some progress has been made in strengthening transparency and competition in public procurement as the authorities implemented a number of measures, especially the amendment to the Public Procurement Act. The new e-procurement system has been introduced as of 1 January 2018, which is a big step towards further increasing transparency and competition. Its efficiency and impact is still to be seen in the coming years. On the regulatory environment in the services and retail sector, limited progress has been achieved. Regarding labour market, education and social policies, some progress has been made in better targeting the public work scheme and reinforcing other active labour market policies reflecting the efforts made by the authorities in this area. Table 2.1:Summary table in 2017 CSR assessment Source: European Commission Box 2.1: Tangible results delivered through EU support to structural change in Hungary Hungary is a beneficiary of significant European Structural and Investment Funds (ESIF) support and can receive up to EUR 25 billion until 2020. This represents around 3 % of GDP annually over the period 2014-2018 and 43% of public investment (1). By 31 December 2017, an estimated EUR 23.5 billion (94 % of the total) was allocated to projects on the ground. This has paved the way for 11 000 enterprises to improve their capacity and over 200 firms to introduce new products to the markets they operate in; for the increase of the urban transport system's sustainability and the decrease of annual primary energy consumption of public buildings. Out of the EU financing, EUR 2.3 billion is planned for delivery via financial instruments (a substantially higher amount than in the 2007-2013 period). ESIF help address structural policy challenges and implement country-specific recommendations. Actions financed cover the promotion of R&D in the private sector via targeted incentive schemes to support innovative SMEs. A substantial share of funds is devoted to ensuring the sustainability of Hungary's transport infrastructure. Funds are targeted to the modernisation of public education (including combatting early-school leaving and segregation), the reduction of labour market mismatches (through enhancing employability of disadvantaged groups, vocational education and lifelong learning) and the improvement of the effectiveness of the justice system. Early childhood care and social inclusion measures, especially for Roma, are also important areas of investment. The funding will also support Hungary's efforts to improve the quality of its public administration. To combat youth unemployment, Hungary received support from the Youth Employment Initiative (YEI), which – accompanied by ESF funding under the same project – benefited over 63 000 young people until the end of 2017 in the respective YEI regions. Support is provided for modernising the agricultural and the agri-food sector, enhancing environment friendly farming and investments in resource efficiency, and fostering local development in rural areas. Several reforms were undertaken already as precondition for ESIF support (2). The compliance with the ex-ante conditionalities assured that the necessary national structures exist to efficiently implement ESIF funded projects. This includes targeted investments in R&D via smart specialisation, the improvement water pricing policy; the elaboration of a transport plan, the development of an employment profiling system and a monitoring system of early school leaving, the enhancement of higher education and health policies as well as measures in the area of public procurement. Hungary is advancing the take up of the European Fund for Strategic Investments (EFSI). As of December 2017, overall financing volume of operations approved under the EFSI amounted to EUR 73 million, which is expected to trigger total private and public investment of EUR 1.2 billion. No project involving Hungary has been approved so far under the Infrastructure and Innovation Window. Under the SME Window, 7 agreements with financial intermediaries have been approved so far. Over 12 000 smaller companies or start-ups will benefit from this support. Funding under Horizon 2020, the Connecting Europe Facility and other directly managed EU funds are additional to the ESIF. By the end of 2017, Hungary has signed agreements for EUR 1.1 billion for projects under the Connecting Europe Facility. https://cohesiondata.ec.europa.eu/countries/HU (1) Public investment is the sum of gross fixed capital formation, investment grants and spending on agriculture. (2) Before programmes are adopted, Member States are required to comply with a number of so-called ex-ante conditionalities, which aim at improving conditions for the majority of public investments areas. European Structural and Investment Funds are pivotal in addressing key challenges in Hungary. Notably, the funds support innovative SMEs, energy efficiency, the promotion of R&D in the private sector as well as the reduction of labour market mismatches through enhancing employability of disadvantaged groups, vocational education and lifelong learning. They also contribute to the modernisation of the public education system, including the combating of early-school leaving and segregation. European funding is also instrumental for supporting public administration reform and the improvement of efficiency and transparency of the public sector (see Box 2.1). 3. Reform priorities 3.1. Public finances and taxation Taxation

Hungary's high tax burden is set to moderate. According to the latest data for 2016, Hungary's total tax burden amounted to 39.3% of GDP, somewhat higher than the EU average and well above the level of regional peers. The tax burden is forecast to decrease by some 2 pps. by 2018 reflecting considerable tax cuts. These most notably include a substantial reduction of employer's social contributions, the lowering of the corporate income tax rate to 9% from 19% and the application of reduced VAT rates for selected goods and services. While the tax-to-GDP ratio remained persistently high, there were notable changes in the tax structure. The share of tax revenues from the taxation of labour decreased, while the weight of consumption and other forms of indirect taxes increased. With the most recent tax package, this trend continues. At the same time, the medium-term fiscal risks could increase in the absence of sufficient compensating measures. A long-standing challenge has been the high tax wedge on labour, particularly for low-income earners. With the introduction of a uniform tax rate in 2011 and the phase-out of tax credits at low incomes in 2012, progressivity in the personal income tax system was eliminated. At the same time, labour taxation has incorporated various elements that moderated the tax wedge on low income levels. These include targeted social security allowances for certain groups of disadvantaged workers under the Job Protection Act (JPA), and family tax credits, which were made increasingly generous (see also European Commission, 2017a, pp 14-15). Nevertheless, the tax wedge for low-income earners remained generally high. In 2016 (the last year with comparable figures), Hungary still had the highest tax wedge within the EU for single earners both at 50 % and 67 % of average wage levels. As part of the multiannual programme to reduce the tax wedge, employers' social contribution rate was lowered altogether by 7.5 pps. in 2017-2018. With the rate of 19.5% applicable from 2018, the measure is estimated to reduce the tax wedge of single earners at 67 % of the average wage by some 3 pps. to 45 % (and to 43 % for workers eligible for the contribution allowances of the Job protection Act). Despite the noticeable reduction, the tax wedge for low income earners without children still remains well above the EU average of 37% (Graph 3.1.1). At the same time, for low income household categories with two children, the reduction in the tax wedge is more substantial due to the continuing increase of child tax credits. For such households, the tax wedge decreases to a level around the EU average. Graph 3.1.1:The evolution of tax wedge for a single worker earning 67% of average wage Source: OECD (2017a), European Commission calculations There remains a scope to shift the tax burden to relatively growth-friendly taxes. Revenues from environmental taxes stood at around 2.5% of GDP in recent years, in line with the EU average (European Commission, 2017b). Available assessments suggest that there is a potential to increase the reliance on environmental taxes (Eunomia 2016). Receipts from car taxation stagnated in recent years, while tax-subsidies persist favouring the private use of company cars. Household energy consumption remains exempt from energy taxation. Recurrent taxes on immovable property amounted to 0.6% of GDP in 2015 compared to the EU average of 1.6%. As the tax base typically does not depend on market value, revenues from property taxes do not benefit from recent increases in property prices. Sector-specific taxes imposed on several businesses still complicate the tax system. Such taxes raise concerns on account of creating distortions, and weakening the investment climate in general (European Commission, 2017a, p. 14). Some sector-specific taxes have been reduced or phased out (partly in response to legal actions by the Commission). However, revenues from sector-specific taxes were still around 1.5 % of the GDP in 2016 (down from the peak at 2% in 2013). In 2017, the upper rate of the bank levy was lowered further. At the same time, the advertisement tax paid by companies publishing or broadcasting ads was increased. The public utility tax is levied on infrastructure ( ) and thus creates a clear disincentive for investments. In addition, this tax is not recognised in regulated prices as a cost item with a direct impact on the profitability of the concerned companies. The complexity of the tax system generates administrative burdens. Hungary operates some sixty tax modalities, with a multitude of small taxes, which yield only minimal proceeds. Several goods and services are simultaneously subject to a number of tax levies often applying different tax bases. The most recent example is the introduction of a sector-specific sales tax ("tourism development contribution") for restaurants in parallel with the reduction of the VAT rate on restaurant meals to 5 %. While the standard VAT rate (at 27 %) is the highest in the EU, reliance on reduced VAT rates as a way to lower consumer prices and boost spending has recently increased. Considerable efforts have been made to reduce high compliance costs. According to a 2015 Eurobarometer survey, 39% of SMEs considered that the costs of tax compliance posed a major obstacle to their business and 55% reported that dealing with tax administration became more difficult over the past five years (European Commission, 2015a). Based on the latest estimate for 2016, the average time spent to meet main tax obligations amounted to 277 hours a year for an SME, the second highest figure in the EU (WB-PWC, 2018). Recent developments seem to indicate an improvement in this regard (GHCIC, 2017). Simplified corporate taxation regimes for small businesses ('KATA' and 'KIVA') have been modified to increase the number of eligible taxpayers. From 2018, draft tax returns for excise duties will be prepared by the tax authority and taxpayers classified as 'reliable' will benefit from a shorter (30 days) refund period for VAT. In 2017, the government launched a modernisation programme of the tax authority to adopt a more client-centred approach in tax collection through digitization and process redesign. Measures implemented over the past years to reduce tax avoidance and fraud produced significant revenue yields. In particular, the introduction of online cash registers starting in 2014 contributed to increased VAT revenues. The VAT gap (i.e. revenue loss relative to total tax liability) is estimated to decline from 21% in 2013 to 14% in 2015, close to the EU average (CASE, 2017). In 2017, the use of online cash registers was extended to further services. From July 2018, a system of online invoicing is scheduled to operate, which will allow the real-time monitoring of invoices issued between businesses. There are some indications that the country's corporate tax rules are used by companies that engage in aggressive tax planning (ATP). Hungary records relatively high capital inflows and outflows through special purpose entities, which have no or little effect on the real economy (OECD 2016a) ( ). The absence of withholding taxes on dividend, interest and royalty payments made by companies based in Hungary may lead to those payments escaping tax altogether, if they are also not subject to tax in the recipient jurisdiction. This may facilitate ATP (ZEW (2016). It is important to note that Member States will have to transpose the provisions of the Anti-Tax Avoidance Directives into national law by the end of 2018 and 2019. In that respect, Hungary modified its rules on controlled foreign companies in 2017. Hungary recently revised its patent box regime (i.e. preferential treatment of incomes from intellectual property), which has been approved by the Code of Conduct on Business Taxation Group. The old regime will be fully phased out by June 2021. While the evidence on the effectiveness of patent boxes as a means to encourage R&D remains limited (CPB, 2014), they may be used as a tax competition tool (Alstadsæter et. al. (2017). It will be important to assess to what extent the new measures, in conjunction with the effect of the transposition of the Anti-Tax Avoidance Directives, will limit the scope for aggressive tax planning in Hungary. Quality of public expenditure Hungary’s public expenditure is high relative to its income level. The government expenditure-to-GDP ratio was hovering around 50% of GDP in the last decade, somewhat above the EU average (Graph 3.1.2). EU fund absorption has played an increasing role in shaping the level public spending since 2004. However, Hungary's level of public expenditure remained well above its regional peers even after filtering out the effect of EU funds. At the same time, public expenditure without EU funds moderated decreasing below the level seen in the pre-crisis period. This was primarily a result of contained spending on social transfers and the public wage bill. Declining interest outlays also contributed to this trend. Graph 3.1.2:Evolution of public expenditure as share of GDP Source: Eurostat and Commission calculations The Hungarian budget spends relatively little on social protection and health care. Against the general trend in the EU, spending on social protection decreased in Hungary in terms of GDP on the back of effective parametric pension reforms and nominal freezing of several social benefits (Graph 3.1.3). The latter contributed to the weakening of social safety net (see Section 3.3). Public expenditure on healthcare has also declined since 2005, albeit the most recent data point to some reversal of this trend (see Section 3.4). The largest fall occurred in the pharmaceutical budget reflecting a series of cost-containment measures. Spending on healthcare is markedly lower than the EU average, which may add to the country's unfavourable health outcomes. Over the last decade, public expenditure on education decreased by around 1 % of GDP to the level of EU average, since 2014, however, some increase took place. This was driven by shrinking government spending on primary education, while administration costs in the sector increased. Graph 3.1.3:Composition of general government spending in the average of 2013-2015 Source: Eurostat COFOG statistics Spending on public administration and economic affairs is comparatively high. Expenditure on economic affairs is well above the EU average and has risen noticeably since 2010. This development is linked to increased state involvement in the economy, the extension of the public work scheme and elevated infrastructural investments. Extensive state involvement in the economy may lead to lower competition and hinder productivity improvements especially if accompanied by a limited effectiveness and quality of public institutions (Fournier and Johansson, 2016; see also Section 3.4). Spending on general public services is well above the EU and regional average. It has even increased despite the centralisation of public administration. Public debt sustainability Hungary's public debt ratio has been declining since 2011, but remains high for a middle income economy. In 2016, the government debt-to-GDP ratio reached 73.9, decreasing by 6 pps. from the peak in 2011. Sovereign risks have been contained thanks also to the declining share of foreign owned and foreign currency denominated debt. The debt reduction was mainly driven by fiscal consolidation, with the primary balance reaching a healthy surplus level above 1.5 % of GDP. The takeover of mandatory second-pillar private pension assets (around 10% of GDP) by the state was also a supporting factor. However, its impact was largely offset by other below-the-line effects, most notably the revaluation of foreign currency debt. Overall, the "snowball" effect (i.e. the combined effect of interest rate on debt and nominal growth) still made a debt-increasing contribution during 2012-2016. In the short term, government debt is forecast to decline further, while the primary balance deteriorates. The public debt ratio is projected to decrease by more than 3 pps. during 2017-2019, falling below 70 %. The decline is primarily due to a supportive "snowball" effect reflecting the continuing decline of interest outlays and accelerating nominal GDP growth. As a result of fiscal loosening, however, the primary balance is forecast to deteriorate significantly, to a minimal nominal surplus and structurally into a deficit position (i.e. -1 % of GDP). The debt trajectory could flatten out in the medium term without further fiscal adjustment. According to the Commission's no-policy-change scenario, the public debt ratio is projected practically to stagnate at somewhat below 70% over 2019-2028 (Graph 3.1.4) (European Commission, 2018a). The debt reduction is hindered by an estimated slightly negative primary balance throughout the nine-year period. The closing of the positive output gap (and thus the cyclical fiscal component) contributes to an increasing primary deficit.

Graph 3.1.4:Gross government debt ratio: the baseline scenario and alternative trajectories Source: European Commission calculations However, the deterioration of the primary balance is projected to be moderated by declining age-related public expenditure. This reflects savings due to parametric pension reforms. The debt-increasing impact of the primary balance is calculated to be offset by a favourable, albeit modest snow-ball effect. By contrast, if the structural balance was gradually improved to the country's medium-term objective, the debt ratio would fall below 60% by 2028 (see the "SGP scenario", Graph 3.1.3). Based on the Commission's assessment framework, fiscal sustainability risks in Hungary are high in the medium term, while in the long term they have a medium level. The country's medium-term sustainability gap (the "S1 indicator") is estimated at 1.8 % of GDP, pointing to medium-level risks. This is the size of fiscal adjustment to be implemented over the next five years, which would bring down the debt ratio to 60% by 2032. Overall, however, the medium-term sustainability risks are assessed to be high as the debt ratio is expected to remain above 60% in 2028 and still displays high sensitivity to shocks. The long-term sustainability gap (S2) is at 4.5 % of GDP, implying medium-level risks. This is the upfront fiscal adjustment ensuring that the debt ratio would not move on an ever-increasing path. Fiscal framework The authorities recently adjusted their domestic regulation to ensure compliance with the budgetary frameworks directive. In autumn 2017, amendments were adopted to the Public Finance and the Economic Stability Acts. These legislative improvements have taken place, most notably, in the following areas: (i) reinforcing the domestic budget balance rules by clarifying their binding effect and ensuring their monitoring by the Fiscal Council for the entire budgetary process; and (ii) enhancing the multi-annual perspective of budgetary planning by the systematic use of a no-policy change scenario as a numerical benchmark. Despite these steps, most of the gaps in the fiscal governance system identified in previous Country Reports do not appear to be resolved. Those include the limited role of the medium-term budgetary framework in fiscal policy decisions and the imbalance between the analytical remit of the Fiscal Council and its strong veto competence. The weak transparency of public finances does not help in improving the quality of fiscal policy-making. On the basis of the Open Budget Indexes in 2015 and 2017, which measure the availability and information content of key fiscal planning and oversight documents, Hungary had consistently the lowest rank among the surveyed EU Member States (IBP, 2015; 2018). Moreover, there are other factors not covered by this index, which weigh on transparency. Budget documents do not contain the updated official estimates for the current year's expenditure and revenue items (i.e. the basis for next year's planning). There are frequent within-the-year amendments of the budget law, scheduled on a rather discretionary manner. It is worth pointing out that the brought forward calendar of budget-making (with the final vote by mid-June on next year's budget) could not fully realise its primary objective of increasing the predictability of fiscal policy. The government repeatedly announced new measures with major impacts on public finances outside this policy cycle. 3.2. Financial sector Economic risks for the banking sector appear to be contained mirroring the improving economic situation. Hungarian banks comfortably meet regulatory requirements. While asset quality has further improved the ratio of non-performing loans is still high, bringing to the fore the importance of well-functioning insolvency frameworks. Operating costs remain high. The improved profitability in 2016 was largely due to one-off items. On account of higher bank profits and improved credit demand, new loans picked up and have contributed moderately to the GDP growth. The five largest credit institutions still hold around half of total banking sector assets, which gives the sector a medium concentration ratio in the EU. The domestic banks account for around 50% of total banking sector assets. Financial soundness indicators across the sector further strengthened. The banks' capital position was materially enhanced by major improvements both in the Tier 1 and overall capital adequacy ratio which amounted to 15.1 % and 17.2 % respectively in June 2017 (see Table 3.2.1). However, these ratios are still rather low compared to other EU countries. The loan to deposit ratio has been largely rebalanced from almost 140 % in 2010 to around 75 % in June 2017. Hungarian banks' funding position has shifted from market funding in the crisis to deposits, which accounted for 62 % of the total assets in June 2017. Table 3.2.1:Financial soundness indicators, all banks Source: ECB, CBD Banks are making rapid progress in cleaning up their balance sheets. While the level of non-performing loans (NPLs) held by banks dropped further to 6.9 %, it still exceeds the EU average of 3.5%. The coverage ratio was around 60 % in mid-2017 (Graph 3.2.1). The improvement in the NPL ratio was primarily due to significant portfolio cleaning over the last 24 months. In June 2017, the ratios of both corporate and household NPLs were half of the overdue portfolio held 2 years before. While the remaining NPLs do not pose a major risk to the stability of the sector, it may still be costly for banks to divest them. These are low-quality assets in general and their book values largely exceed market prices. Graph 3.2.1:Development of the NPL ratios Source: ECB Hungarian banks generated large profits thanks to one-off items. All major banks closed 2016 and H1 2017 with outstanding profits. In 2016, the return on equity of the eight largest banks reached levels of between 19.6 % and 6.6 %, far exceeding the EU average of around 5 %. However, profits were mostly made thanks to one-off items such as reversed provisions and the sale of shares in VISA Europe. Low competition and therefore relatively high interest rates on the household credit segment contributed to the large profits as well. However, recently interest margins have started to compress partly on the back of the certified consumer-friendly housing loan scheme introduced by the authorities. Moreover, the sector booked losses on portfolio cleaning. To compensate for these, banks have increased their revenues on fees and commissions in 2017. Banks put an end to a long period of deleveraging as new lending picked up. The banking system’s total assets-to-GDP ratio decreased from 124% in 2010 to 100% in June 2017 (see Graph 3.2.2). In 2016, the decline in outstanding household loans was halted and new household loans grew in annual terms by 43% in Q3 2017. As a result, in H1 2017, the stock of household loans expanded by 3.3% in annual terms. Similarly, the stock of corporate loans increased by more than 8%, with SME lending up 13%, in Q3 2017 (see Graph 3.2.3). The three sources of financing most commonly used by Hungarian SMEs recently are credit lines (29 %), leasing (21 %) and grants (12 %) (European Commission, 2017c). Loans to Hungarian firms and household continued to benefit from supportive measures. However, the Funding for Growth Scheme was discontinued to make room for market lending. The sector's aggregate exposure to the booming real estate and construction sector has been growing again. In Q3 2017, it accounted for 25 % of total loans to corporates (still below the record of 36 % in 2011). Graph 3.2.2:Banking system assets to GDP Source: ECB With a new credit cycle on the horizon, the central bank aims to improve the quality of lending. It is encouraging banks to offer fixed interest rates loans to households rather than variable ones which are considered less safe. According to the central bank, many corporate loans are offered with too short maturity making the access to credit by businesses more burdensome. The efficiency of the Hungarian banking sector remains an issue. The banking sector has shed a fourth of its branches since 2008 and operates with 11 % less staff. However, the economy remains overbanked in EU comparison. The uptake of digital banking services is one of the lowest in the EU. The banking sector struggles to hire experts to bolster their digital arms. The operating expenses of Hungarian banks amounted to over 3 % of total assets on average at the end of 2016, unchanged since 2015. The cost-to-income ratio is close to 74 %, over 10 pps. higher than the already high average of euro area banks and 20 pps. higher than some of the regional peers. Low efficiency of the sector may give rise further consolidation. Graph 3.2.3:Corporate and household loans growth rate (y-o-y) Source: ECB The state remains an active player in the financial sector. It maintains a high presence across the sector and is proceeding slowly with privatisation. The state continues to be a majority shareholder in a few local commercial banks. It also owns the fast-growing Eximbank whose lending business goes beyond its traditionally supported export activity of corporates. At the same time, the Hungarian Development Bank and the financial arm of the state-owned Hungarian Post are expanding their lending activities by targeting SMEs and retail clients. The state remains the main shareholder of the Budapest Stock Exchange (BSE) through the central bank. Given that the BSE is also supervised by the central bank, the current ownership setup raises governance issues. As part of its capital market development strategy, the BSE launched a dedicated multilateral trading facility for medium-sized companies in 2017. It offers lower fees and regulatory requirements. The government also promotes the domestic ownership of banks. This process and high government involvement in the banking sector create new challenges for the banking supervision. As the experiences of other countries in the region also show, these types of banks are more vulnerable to corporate governance problems, which in turn can lead to problems with credit allocation, credit risk control and asset quality.

Box 3.2.3: Housing prices in Hungary Hungary experienced the strongest rise in house prices in the EU in 2015 and 2016 with an annual increase of around 13.5% in real terms. At the regional level, house prices in Budapest show a much stronger increase than in the rest of the country. In spite of the recent increase, house prices remain below the peak reached in 2007 and valuation metrics such as the price-to-income and price-to-rent ratios are below their long-term average. Taking into account the various macroeconomic fundamentals driving house prices (Philiponnet et al., 2017) over-valuation risk appears limited, although recent price increases have been stronger than what fundamentals would suggest. Recent data indicates that house price growth has slowed down in the course of 2017, possibly signalling a more mature market. Beyond development in prices, the number of building permits also increased sharply since 2015. The number of building permits granted in 2017 is now close to the levels reached before the financial crisis. Still, supply is very heterogeneous across regions. In particular, the number of house built in Budapest in 2016 is close to three times lower than the pre-crisis level (MNB, 2017), suggesting that lagging supply may impact price dynamics in the capital. The steep increase in house prices was supported by several factors. The relatively large undervaluation of the Hungarian real estate market attracted foreign buyers in a low yield environment. Domestic buyers who delayed their purchase for many years after the crisis suddenly stepped in using their accumulated savings. In addition, new fiscal measures of the government also boosted the demand. In the first period of the price increase, the transactions were mainly credit free. More recently mortgage loans play an increasing role. However, the ratio of outstanding mortgage to GDP stood at 9% in the second quarter 2017 well below the EU average and below peers in the region. Overall, given the strong correction in house prices recorded between 2007 and 2013 and the recovering economic fundamentals, there is limited indication of overvaluation on the residential real estate market at the aggregate level. In addition, the consequence of a potential correction would be mitigated by the low indebtedness of households. However, the developments should be carefully monitored. 3.3. Labour market, education and social policies Labour Market While the employment is at a record high level, some challenges remain. The Hungarian labour market has markedly improved since 2013, with the employment rate for the age group 20-64 reaching 73.0% for Q1-Q3 2017 and the unemployment rate falling to 4.3%. Increasing shortages in the labour market are coupled with large differences in employability of various skills groups. The Social Scoreboard supporting the European Pillar of Social Rights (Box 3.3.1) suggests a number of challenges: a relatively high rate of early school leaving, high gender employment gap, and low participation in formal childcare below the age of 3. Graph 3.3.1:Change in real productivity, real GDP per capita and real wages (2008-2016) Source: European Commission calculations Wage convergence has restarted. The period between 2009 and 2015 saw strong wage moderation, helping to regain cost competitiveness amid the crisis, but making Hungary lag behind in terms of wage convergence (Graph 3.3.1). Based on 2016 data, the compensation of employees was significantly below EU average. The high wage dynamics, which already started in 2016, signifies a turnaround in this trend. However, wage acceleration carries the risk that imbalances start building up again, if it does not remain in line with productivity over the medium term. Wage growth is driven by labour market tightening and sharp minimum wage increases (15 % in 2017 and 8 % in 2018). To ease the impact of wage increases on labour costs, social security contributions were reduced (see Section 3.1). The duration of unemployment benefits is still the shortest in the EU at maximum 3 months. With the average duration of unemployment is close to 12 months, this does not give enough time to find an adequate job (European Commission 2017d, p. 40). The level of unemployment benefits (i.e. the net replacement rate at 2 and 12 months) is among the lowest in the EU, as shown by the benchmarking exercise of the Employment Committee (European Commission, 2017e). The size of the public works scheme (PWS) has started to diminish and the government is taking further steps in this direction. Participation in the PWS dropped by about 15 % in the first half of 2017, but the scheme remained the dominant form of active labour market policy (ALMP). The PWS is less effective than other tools in bringing participants back to regular employment and may even reduce the probability of finding a job (Molnár et al., 2014; Fazekas and Varga, 2015). According to data from the Interior Ministry, only 12.4 % of participants were in regular employment six months after leaving the scheme in the first quarter of 2017. A recent government decree aims to limit the participation in the scheme in favour of other ALMP measures. The 2018 budget allocation on PWS is reduced by around 20%, while still absorbing more than a half of all spending on labour market policies. Other active labour market policies, co-funded by the European Social Fund, are progressing well. The two flagship ESF and YEI programmes aiming to improve the employability and labour market entry for jobseekers and inactive people, covered more than 173 000 persons between 2015 and 2017. Results on the effectiveness of those measures are not available yet. The Public Employment Service (PES) profiling system is improving. Currently, the classification of jobseekers into different profiles is strongly affected by targets set for various employment programmes. This distortion is likely to decrease along with the size of PWS. The system will be also extended to cover competences and employability potential of individuals. However, the dispersed management structure of the PES hinders efficiency, leading to difficulties in the coordination of different ALMPs and insufficiently targeted interventions. Box 3.3. 1: Monitoring performance in light of the European Pillar of Social Rights The European Pillar of Social Rights, proclaimed on 17 November 2017 by the European Parliament, the Council and the European Commission, sets out 20 principles and rights to benefit citizens in the EU. In light of the legacy of the crisis and changes in our societies driven by population ageing, digitalisation and new ways of working, the Pillar serves as a compass for a renewed process of convergence towards better working and living conditions. Hungary performs well on a number of indicators of the Social Scoreboard (1) supporting the European Pillar of Social Rights, but challenges remain. It has relatively high employment, and low unemployment and income equality. On the other hand, the share of early leavers from education was already at high levels and increased further in the last period. The shares of early leavers from education and of NEETs are particularly high for Roma. A large part of population faces severe housing deprivation. The gender employment gap is the highest for the age group 25 to 39 years, showing a high impact of motherhood on labour market participation. The sources of this problem include little flexibility in working schedules, the low take up of family leaves by fathers and the scarcity of childcare facilities for children under 3 years of age. ESIF resources have been allocated to address the last of those challenges. Active labour market programmes targeting young people have been successful in Hungary. The Youth Guarantee (YG) and the Youth Employment Initiative, supported by the European Social Fund, are delivered via the networkin of Public Employment Services (PES) providing a country-wide coverage. These programmes involved more than 74 thousand young people between January 2015 and November 2017 and most participants 2016 received training or an employment offer within 4 months of registering with the PES. Recent government legislation (20/3/2017) extends further the outreach of the YG by imposing stricter limitations for young people to be involved in the Public Works Scheme. On the back of these initiatives the youth unemployment rate and the share of young people not in education, employment or training (NEETs) have been decreasing. (1) The Social Scoreboard is composed of 14 headline indicators, of which 12 are currently used to compare Member States' performance. The indicators "participants in active labour market policies per 100 persons wanting to work" and "compensation of employees per hour worked (in EUR)" are not used due to reservations by Member States. Possible alternatives will be discussed in the relevant Committees. Abbreviation: GDHI - gross disposable household income. Low-skilled workers continue to face low employment rates and prospects, as well as low wages. The gaps between the employment rates of low-, medium- and high-skilled workers have been higher in Hungary than elsewhere in the EU (European Commission, 2017a). Wage differences across various skills levels are also very high in an international comparison (Graph 3.3.2). Despite the high skills premium, few adults decide to upskill. Recent employment growth has been uneven for men and women. In 2016, the gender employment gap amounted to 15.2 pps. (above the EU28 average of 11.5 pps.), pointing to an untapped reserve to address labour shortages. The gap slightly increased in recent years. This occurred mostly among the 25-39 old age, despite a recent reform of the long parental leave system, which aimed to facilitate the return of young parents (mainly mothers) to work. On the other hand, main earners (often men) are not encouraged to take up the leave. This is coupled with a short supply of quality childcare. The enrolment in formal childcare of the 0-3 year old stands at 15.3 %, which is well below the EU average of 30.3 %. The coverage is even lower in the poorest counties with a high ratio of disadvantaged population. From January 2017, new types of childcare facilities have been introduced. European Social and Investment Funds (ESIF) were allocated to increase the capacity of day-nursery facilities, which should lead to supply increases in the years to come. Funds dedicated to cover operational costs are to be increased from HUF 17 bn in 2017 to 37 bn in 2018. Graph 3.3.2:Wage premium of educational attainment as compared to low education Source: European Commission calculations People with disabilities are under-represented in the labour market. Their participation in employment is one of the lowest in the EU (39.6 % vs. the EU average of 47.4 %). This hampers social and employment integration, leading to high risk of poverty or social exclusion for this group (32.2% vs. the EU average of 29.9 %). Several measures have been launched to incentivise employers to hire people with disabilities, but their impact is still to be seen. Measures to improve integrated living conditions (replacing institutional long-term care) supported by local community-level public services do not seem to be sufficient. Integration of Roma in the labour market remains a challenge. Between 2011 and 2016 the employment rate among Roma increased from 25 % to 36 %, but a large share of those in employment (41.6 %) work in the PWS. The NEET rate of young Roma has significantly increased (by 13 pps.) and stands now at 51 % (COM-FRA 2017). With only 26 % of Roma women in paid work, the gender employment gap among Roma reaches 19 pps. (FRA, 2016). Social dialogue structures and processes in Hungary remain underdeveloped. The weaknesses of existing structures of social dialogue at bipartite and tripartite levels do not allow for a proper and meaningful involvement of social partners in the design and implementation of relevant policy reforms. The National Economic and Social Council (involving also civil society organisations and other stakeholders) cannot be considered an adequate forum for tripartite social dialogue, as it does not include the government. The Permanent Consultation Forum of the Private Sector has only a narrow scope of competences and agreements concluded are legally non-binding. In consequence, social partners are not involved in the preparation of inputs to the European Semester or in the implementation of the relevant country specific recommendations. Cutbacks in government-provided resources further reduced the institutional capacity of social partners. The collective bargaining system is weak and takes place mostly at company level. Recent studies by Eurofound (2016, 2017) note that social partners are rarely consulted by government beyond wage matters. Collective bargaining coverage rate stood at 22%, the fifth lowest in the EU (Visser, 2016). Poverty and social inclusion The overall poverty situation is notably improving, but poverty risks faced by vulnerable groups remain high. The share of population at risk of poverty or social exclusion (AROPE) was at 26.3 % in 2016, 1.9 pps. lower than a year earlier, approaching the EU average and closing the gap to the national EU 2020 target. This positive development is mainly due to falling severe material deprivation and a decrease of the number of people living in low work intensity households. On the other hand, relative monetary poverty remains unchanged (Graph 3.3.3), particularly affecting Roma, whose exposure to poverty is three-four times higher than for the rest of the population.( )

Graph 3.3.3:Main poverty indicators since 2005 Source: Eurostat, EU-SILC While remaining below the EU average, income inequalities rose during the crisis and have not yet started to decrease following the recovery (see Section 1). In 2010, the richest 20 % of the population received 3.4 times as much income as the poorest 20 %. By 2013 this ratio grew to 4.3 and then stabilised. In parallel, the poorest quintile of households saw their share in total income to decrease from 9.5 % in 2007 to 8.8 % in 2016 (see also GKI, 2017). Changes in the tax and benefit system significantly contributed to rising income inequality (De Agostini et al. 2016, European Commission, 2017b, pp. 60-62). Children in general are more exposed to poverty than other age groups in Hungary. In 2016, 33.6 % of the young aged was at risk of poverty or social exclusion compared to 26.3 % of the total population and above the EU average of 26.5 %. Households with children are more likely to be poor than those without children (29.6 % vs. 23 %). Risk of poverty affects 38.4 % families with more than 3 children and 62.3 % for lone parent families. Child poverty is linked with a significant inequality of opportunity. Parental background has a strong impact on educational performance and children of low-skilled face a high risk of poverty. A considerable part of the population faces severe housing deprivation. The respective rate stood at 16.9 % of the population in 2016 compared to the EU average of 4.8 %. This proportion reaches one-third among those at risk of poverty or social exclusion, and one-fourth under 18 years of age. Housing deprivation among Roma persists with 33 % of Roma living in households without access to drinking water and 38 % lacking other basic amenities such as toilet, shower or bathroom (COM-FRA 2017). No significant improvement is visible in the field of social housing (Habitat, 2017). The social safety net is weak as social policies put an emphasis on meeting needs by work related income. Meanwhile, as demonstrated by a benchmarking exercise (European Commission, 2017e), the adequacy of minimum income benefit (FHT) is one of the lowest in the EU, below 50 % of the poverty threshold. There is no indexation system for the social assistance benefits and the reform of cash benefits led to a high degree of discretion by municipalities (European Commission, 2017a). The low wage provided by PWS (one-third below minimum wage) is not sufficient to reach the poverty threshold for many participants. In fact, PWS might be a key factor behind the increased in-work poverty of workers with temporary contracts (from 14 % in 2010 to 29 % in 2016). There has been a clear shift from social benefits toward family support and in-kind benefits (e.g. free or discounted school meals, holiday programs, free school textbooks). Most of the in-kind benefits are not targeted at low income families, or the applied means tests are high enough to cover middle income families as well. The largest expenditure growth affected child tax credits, home-ownership supports (CSOK) and work-related child-care allowances, which benefit only those at work. By contrast, public spending on means-tested social allowances and universal family and childcare benefits decreased in real terms with nominally frozen benefit levels. Education and skills The basic skills outcomes of 15-year-olds are significantly below the EU average. According to the OECD's 2015 Programme for International Student Assessment (PISA), performance in reading and science deteriorated significantly compared to 2012. Hungary saw the highest increase in the share of low achievers in science in the EU. More than one in four pupils did not meet the basic required level in reading or mathematics. According to an empirical study (Thum and Raciborski, 2017) better PISA results contribute to higher growth potential, highlighting the economic importance of educational quality. In 2016 Hungary announced that the national curriculum would be revised by the end 2017 with ESF support, in part as a response to the declining performance shown by PISA 2015. However, to date no further details regarding the direction of the reform and the involvement of stakeholders in its preparation have been made public. The impact of pupils’ socioeconomic background on education outcomes is the strongest in the EU. The impact of school type on outcomes is also very significant, reflecting early selection in secondary education (Educational Authority 2017). Pupils are tracked into different schools according to their performance starting from the age of 10. Amongst the three types of secondary school, pupils of vocational secondary schools (szakközépiskola), which have the highest concentration of disadvantaged pupils, performed particularly poorly in PISA (Educational Authority 2016). This type of schools shows limited capacity to counterbalance the socio-economic disadvantage that large numbers of their pupils face (Civil School Education Platform, 2016). In 2016, the early school leaving (ESL) rate increased to 12.4 %, above the EU average of 10.7 %. While ESL has been decreasing steadily across the EU, it has not fallen in Hungary since 2010. The problem is especially acute among Roma, for whom the ESL rate stands now at 59.9 % compared with 8.9 % among non-Roma (data provided by the Hungarian CSO). In November 2016 the government adopted an action plan to reduce ESL and introduced mandatory data collection on pupils’ progress at school, which feeds into a digital early warning and pedagogical support system. However, there is no monitoring system for young people who have already dropped out of school. Disadvantaged pupils, including Roma, increasingly attend schools where they are the dominant majority. As a result, the likelihood of contacts between disadvantaged and non-disadvantaged pupils at school declined between 2008 and 2016 (Hungarian Academy of Sciences, 2018). Increasing residential separation and the effect of parental choice on local school enrolment have contributed to this outcome. Despite the state taking over the management of public schools from municipalities in 2013 with the aim of reducing inequalities, 61 % Roma children still attend schools where all or most children are Roma. High concentration of Roma children in certain schools is also present in urban settings, outside of ethnically segregated areas (FRA 2016). Although successful pedagogical models for inclusive education have been developed, only a limited number of mainstream schools actually use them. Amendments to the Equal Treatment and Public Education Acts to prevent segregation were adopted in summer 2017, but they can only have an impact as of the 2018/2019 academic year. ESIF-funded projects were launched in 2017 to support 300 schools in combating school failure and introducing inclusive teaching methods. Teachers are entitled to a salary supplement if working under difficult conditions as of January 2018. However, measures to systematically address existing segregation in mainstream education are lacking. The extension of early childhood education may positively impact the later school performance of disadvantaged pupils. Between 2011 and 2016, participation of Roma children in early childhood education and care significantly improved, increasing from 81% to 91%. This is the highest participation rate in the region. Teacher salaries have increased faster than the public sector average since 2013, but were still 31% lower than those of other tertiary graduates in 2015 (OECD 2017b). In parallel with the increase of the base salary levels, most salary supplements for replacement and supplementary teaching hours were abolished and the number of weekly teaching hours increased from 20-22 to 22-26. In addition, teachers are obliged to stay in school premises for tasks defined by their headmaster for at least 32 hours a week. The growing demand for highly-skilled workforce is not matched by the performance of the higher education. The number of university applicants has been shrinking since 2010, which can only be partially explained by demographic changes. The tertiary educational attainment rate for 30-34 year-olds stood at 33 % in 2016, well below the EU average of 39.1 %. The dropout rates have been declining (35.3% on average) but remain high especially in bachelor and undivided programmes. The 2014 Higher Education Strategy established the position of the ‘chancellor’, who is nominated by the government and takes decisions on strategic and economic matters. This measure earned Hungary the lowest score in the ranking of financial autonomy of higher education institutions across the EU (EUA, 2017a). The recent amendment of the Higher Education Act in April 2017 raised further concerns about decreasing academic freedom (EUA, 2017b). The employment rate of recent vocational education and training (VET) graduates, at 84.4 %, is well above the EU average of 75 %, but shows a wide gap between the two types of VET. VET has two pathways: vocational grammar schools (szakgimnázium) with a higher element of general education and vocational secondary schools (szakközépiskola) for less academically inclined students. General education content in vocational secondary schools is limited. This, together with the concentration of children of low socioeconomic status in those schools, explains the heavy deficit in basic skills measured in PISA. This is further reflected in the high dropout rates. In 2016, the dropout rate in vocational secondary schools was 15.3%, against a 6.5% in vocational grammar schools and 1.1% in general upper-secondary schools (gimnázium) (Hungarian Academy of Sciences, 2018). Their graduates face more difficulties in finding a job and earn lower wages than other secondary school graduates. Promoting adult participation in learning remains a challenge, especially among the unemployed. The overall participation figure was 6.3 % in 2016, well below the EU-28 average of 10.8 %. People in employment were about four times more likely to participate in trainings than unemployed, which contributes to further segmentation of the labour market and increasing skills mismatches at a time when employers are having growing problems in attracting skilled workers. The situation is expected to improve thanks to EU and national funded training programmes, but the substantial gap is unlikely to close. Healthcare Poor health outcomes aggravated by high risks from unhealthy lifestyles, uneven quality of care and inequalities in access are the key challenges faced by the health system. In 2015 life expectancy was 75.7 years in Hungary, almost five years below the EU average. Although life expectancy rose by close to 4 years over the past 15 years, the gap relative to the EU has narrowed only a little (by 0.2 years since 2002, the earliest data point for EU28). Significant inequalities prevail in health status across socioeconomic groups (Orosz and Kollányi, 2016). The gap in life expectancy between Hungarians with the highest and lowest level of education reached 11.7 years for men and 6.7 years for women in 2015. These wide disparities are linked to health risk factors and inequalities in access to care. While showing a decreasing trend, mortality rates remain high reflecting also the limited effectiveness of the healthcare system. Cardiovascular diseases and cancer account for three-quarters of all deaths, with the third highest mortality rate from ischaemic heart diseases and the highest one from cancer in the EU. The amenable mortality rate for Hungarians is about double the EU average. This suggests shortcomings in the provision of timely and quality care. Based on amenable and preventable deaths in 2014, a recent comprehensive assessment estimated that one quarter of total mortality could have been potentially avoided by a more effective healthcare provision (14 %) and health risk prevention (12 %) (Gyenes et al., 2016, see also Box 3.5.1). To address some of these problems, more emphasis has been put on screening programs lately to detect certain types of cancers at an early stage. Recently, a national colorectal screening programme has been launched.

Health risks associated with unhealthy lifestyles remain high. While decreasing from 30% in 2000, still more than one-fourth of adults were daily smokers in 2014, the third highest figure in the EU. Recorded alcohol consumption per adult is about 10 % higher than the EU average, and the prevalence of obesity increased from 18 % in 2000 to 21 % in 2014, becoming the third highest rate in the EU. Nearly 40 % of the total disease burden in Hungary, as measured by the impact on disability-adjusted life years, can be attributed to unhealthy lifestyles (IHME, 2016). Several public health measures were implemented over the past years showing some positive results (Joó et al., 2017). Spending on healthcare is comparatively low. In 2015, total (current) spending on healthcare amounted to 7.2 % of GDP in Hungary compared to the EU average of 9.9 %. In per capita terms, health expenditure is about half of the EU average and the gap widened over the past decade. This was driven by shrinking public spending. Unlike in most EU countries, spending from public sources declined as a share of GDP, from 5.7 % in 2005 to 4.8 % in 2015 (see also section 3.1) (OECD, 2017c). Provisional figures indicate that public health expenditure went up to 5.2 % of GDP in 2016, which was still considerably lower than the EU28 level of 7.8 % (calculations based on OECD (2017c) and the Eurostat Database). Equity in healthcare is put at risk by the high reliance on out-of-pocket payments. Out-of-pocket payments account for 29% of total health expenditure, nearly twice as high as the EU average. This includes informal “gratuity” payments, which adversely affect access to public healthcare and distort incentives for providers (see Section 3.4) While the share of Hungarians reporting unmet needs for medical care due to financial reasons is relatively low (about 2% and similar to the EU average), more than 6% people with low income reported unmet needs because of cost compared with a mere 0.2% in the highest income group (2015 EU-SILC survey). Moreover, 7.4 % of households faced catastrophic out-of-pocket payments in 2014 ( ). This proportion reached more than 27% in the lowest income quintile (OECD/EOHSP, 2017). Efficiency problems also seem to play a role in the limited effectiveness of the healthcare system. Unhealthy lifestyles and the relatively low levels of health spending and economic wellbeing are all important factors behind Hungary's unsatisfactory health outcomes. However, an analysis by Medeiros and Schwierz (2015) suggests the presence of considerable efficiency reserves. The study estimated that Hungary performed in the bottom quarter within the EU regarding health system efficiency as measured by the relationship between resources allocated to healthcare and outcomes achieved. Inefficiencies are related to structural features. The setup of service delivery remains strongly hospital-centred, with notable weaknesses in primary care and care coordination for chronic disease patients (OECD/EOHSP, 2017). Graph 3.3.4:Hospitalisations for ambulatory care-sensitive conditions (per 100.000 population) Source: OECD (2017c) Key efficiency gains are still to be made in the primary care sector. Data on avoidable hospitalisations point to significant opportunities to strengthen primary care (Graph 3.3.3). Except for a few team-based primary care pilots, GPs operate in solo practices (Sinkó et al., 2017). This setting, together with weak incentives and often limited professional capacities to avoid unnecessary utilisation of specialist care, hinder the effectiveness of primary care. Concerns for future accessibility and effectiveness of primary care are exacerbated by the fact that nearly half of GPs are over 60 years old (OECD/EOHSP, 2017). Moreover, the system of marketable practicing rights, coupled with the absence of team-based organisations, create high entry cost for doctors intending to work in primary care. While financial support schemes have been put in place to subsidise the entry of new GPs, around 5% of GP districts were permanently vacant in 2017 (ÁEEK, 2017). The 2015 Primary Health Care Act marked a renewed attempt to reinforce primary care, most notably by redefining tasks of GPs, promoting group practices and revising payment schemes. The impact of these measures still remains to be seen as their implementation progressed slowly so far. The hospital-centred health system has further scope for improvement. The reorganisation of the hospital sector executed in two major phases (in 2007 and 2012) reduced acute in-patient capacities, especially in smaller hospitals, and resulted in the closure of around 10 000 beds overall. However, the number of hospital beds remained far above the EU average (699 compared to 515 beds per 100 000 population), as well as hospital activity rates (OECD, 2017c). There is still room for streamlining in-patient services in order to better concentrate resources for cost-intensive treatments, while shifting less severe cases to ambulatory care settings. As a key step in this direction, the government adopted the Healthy Budapest Programme in 2017 aiming at the modernisation of the highly fragmented hospital network in the capital. In addition, the e-health system launched recently can serve as a valuable tool for improved coordination across levels of care and specialties. The greater use of one-day surgery also offers efficiency gains. The share of day cases in surgical interventions was rising over the past decade and the government has started to incentivise further penetration. However, Hungary still lags behind most EU countries in this regard (Gyenes et al., 2016; OECD, 2017d). While the use of services appears to be more even than the geographic distribution of capacities, important inequalities in access exist. As shown by the above mentioned comprehensive health system assessment (Gyenes et al., 2016), the dispersion of per capita public health spending across regions is relatively narrow. However, this does not account for differences in needs and the fast growing private care. More significant inequalities were found regarding some key aspects of the healthcare process, especially at sub-regional levels. The use of specialist services by people in disadvantaged areas is 20% below the national average, and four-fivefold differences occur in waiting times for elective care between counties. There are also wide geographic variations in mortality rates within 30 and 365 days following stroke or heart attack, which give an indication about the uneven quality of care. Regarding unmet medical needs (related to all reported reasons), inequalities by income are markedly higher in Hungary than generally in the EU.( ) The odds of unmet needs are also estimated to increase significantly for low education level and the Roma (Gyenes et al., 2016 pp. 528-542). Although recent salary increases have a mitigating effect, workforce shortages continue to hamper access to care. Hungary has a somewhat lower number of doctors than the EU average (3.1 per 1000 population vs. 3.6), but shows a larger difference in the number of nurses (6.5 per 1000 population vs. 8.4). The past decade saw a significant outflow of health professionals leaving to work abroad (Varga, 2015). Outward migration, coupled with the expansion of private healthcare, resulted in staff shortages in the public sector. This has restricted access to care, particularly in rural areas. In response, a number of staff retention measures were introduced over the past six years. In 2016, a multi-annual pay-raise programme was launched covering doctors, nurses and other health workers. Recent data on certification requests needed to work abroad show that the emigration of doctors has slowed down (Velkey and Gaál, 2017). At the same time, the age composition of health workers continues to raise concerns about rising future replacement needs (ENKK, 2016). 3.4. Investment Investment trends Total investment surpassed its pre-crisis level in 2017, 3 years after real GDP exceeded its 2008 level.. After the crisis, the investment to GDP ratio fluctuated around 20 %, which is 4 pps. lower than before the crisis. The weak investment performance was due to the drop in private investment reflecting deleveraging needs and weak demand. Business investment declined by almost 20% and returned to its 2008 level in 2017. Household investments practically dropped to half of their level in 2008 and are not expected to recover by 2019. Public investment has been volatile due to the timing of EU funds' absorption, which generates sizable volatility in total investment and GDP variables (see Box 3.4.1.) Graph 3.4.1:Private and public investment Source: Eurostat, European Commission calculations based on the Autumn 2017 Economic Forecast Private investment is set to increase on the back of several supporting factors. Since 2016, a steady recovery has started in private investment. Households' willingness to consume has been gradually picking up, and financial conditions for firms have improved. In the current EU financial framework Hungary allocates around 55% of incoming EU funds to the private sector, which is higher than in the previous period. The reduction of the corporate income tax rate may also motivate firms to invest more. The global recovery improves the prospects of export-oriented companies to build new capacities. Several investment plans have been announced in the manufacturing sector, including the car industry. The main short-term risk to invest is the labour shortage (see Section 3.2). Household investment has started to increase steeply as many supportive elements are kicking-in. Housing investment has risen dynamically since 2016 from a very low level. The number of new homes built in 2015 was 0.8 per 1000 inhabitants, which was one of the lowest in the EU and three times lower than in the pre-crisis period. The growth is supported by the fading precautionary behaviour of households and by government initiated measures, such as Family Housing Subsidy Programme and the temporary cut in VAT for housing construction. The VAT cut will be phased out, which may induce a sudden decline in housing construction (see Box 3.2.1.). Business investment has taken place mainly in large and foreign owned firms, in particular in the export sector (Kopint-Tárki, 2017). Large companies are in a better position to negotiate tailor-made conditions in a country, thus they can insulate themselves from domestic business environment to some extent. The government initiated bilateral strategic agreements with large companies, which