EUROPEAN COMMISSION Brussels, 28.2.2017 SWD(2017) 82 final/2 CORRIGENDUM



This document corrects SWD(2017) 82 final linked to COM(2017) 90 final of 22.2.2017.

Concerns the EN and HU language versions.

Corrections on pages 4, 11, 43 and 46.



The text shall read as follows:

COMMISSION STAFF WORKING DOCUMENT Country Report Hungary 2017 Accompanying the document COMMUNICATION FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT, THE COUNCIL, THE EUROPEAN CENTRAL BANK AND THE EUROGROUP

2017 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(2017) 90 final}

{SWD(2017) 67 final to SWD(2017) 93 final}







Contents Executive summary1 1.Economic situation and outlook4 2.Progress with country-specific recommendations11 3.Reform priorities14 3.1.Public finances14 3.2.Financial sector18 3.3.Labour market, education and social policies21 3.4.Investment26 3.5.Sectoral policies31 3.6.Public administration34 A.Overview Table38 B.MIP Scoreboard43 C.Standard Tables44 References49 LIST OF Tables 1.1.Key economic, financial & social indicators — Hungary10 2.1.Summary Table in 2016 CSR assessment12

3.2.1.Financial soundness indicators, all banks18 B.1.The MIP scoreboard for Hungary43 C.1.Financial market indicators44 C.2.Labour market and social indicators45 C.3.Labour market and social indicators (continued)46 C.4.Product market performance and policy indicators47 C.5.Green growth48 LIST OF Graphs 1.1.Contributions to real GDP growth4 1.2.Export market shares4 1.3.Unit labour cost developments in Hungary5 1.4.Contributions to HICP inflation5 1.5.Activity, employment and unemployment6 1.6.Decomposition of credit flows7 1.7.Net lending / borrowing by institutional sector7 1.8.Per capita GDP in PPP terms8 1.9.Average annual rate of real convergence8 1.10.Contributions to potential growth8 3.1.1.Tax wedge of a single worker earning 67% of average wage15

3.1.2.Gross government debt ratio: the baseline scenario and alternative trajectories16 3.2.1.Non-performing loans, 90-day+ ratios18 3.2.2.Net NPLs to own funds (%)18 3.2.3.Growth rate of outstanding loans19 3.2.4.Lending conditions in the corporate sector19 3.3.1.Relative dispersion of employment rates by education level, 2010, 2014 and 201521 3.3.2.Main poverty indicators, 2005-201523 3.4.1.Private and public investment in HU and the EU26 3.4.2.Investment volumes, index 2008=10026 3.4.3.Greenfield FDI inflows into Hungary27 3.5.1.The evolution of R&D intensity by sectors31 3.5.2.Performance of Hungarian SMEs in selected innovation indicators – measured in standard deviations (EU average=0)31 3.6.1.Hungary: Quality of institutional performance - 2005-201534 LIST OF Boxes 1.1.The minimum wage increase and tax reform9 2.1.Contribution of the EU budget to structural change in Hungary13 3.2.1.House price developments20 3.4.1.Hungary's weak post-crisis productivity growth hinders competitiveness28 3.4.2.Investment challenges and reforms in Hungary30

3.6.1.Selected highlights37 Executive summary This report assesses Hungary’s economy in the light of the European Commission’s Annual Growth Survey published on 16 November 2016. In the survey the Commission calls on EU Member States to redouble their efforts on the three elements of the virtuous triangle of economic policy — boosting investment, pursuing structural reforms and ensuring responsible fiscal policies. In so doing, Member States should focus on enhancing social fairness in order to deliver more inclusive growth. The performance of the Hungarian economy remains solid, increasingly driven by domestic demand. Real GDP has surpassed its pre-crisis peak. Potential growth however still remains a full percentage point lower than before the crisis, despite the recovery in recent years. In 2016, GDP is estimated to have increased by 1.9 %, supported by strengthening private consumption and net exports. A temporary decline in EU-funded investment reduced growth in 2016, but continuing support from private consumption, a gradual recovery in EU-funded investment, and expansive fiscal policy is likely to accelerate growth to around 3.5 % as of 2017. Higher energy prices and significant minimum wage increases are expected to push up inflation towards the central bank’s target rate of 3.0 % by the end of 2018. The labour market situation continues to improve, but with growing signs of tightening. Unemployment fell below its pre-crisis level, despite a rapidly increasing activity rate. Long-term unemployment also fell. The supply of labour rose, due to restrictive policies on social transfers, early retirement and increasing statutory retirement age. Owing to the increasing activity rate, labour has become a positive contributor to the potential growth rate despite population ageing. However, shortages of both skilled and unskilled workers have emerged in various sectors and companies find it increasingly difficult to fill vacancies. After a significant drop in 2016, investment is forecast to recover progressively. The considerable investment growth in 2013-2014 came to a halt as EU-funded investment temporarily subsided. In addition, private investment is hampered by still-cautious lending activity and frequent changes to the regulatory and tax environment. Factors adversely affecting the business environment are linked particularly to weaknesses in institutional performance and governance. An increase in productive investment, especially in equipment and machinery, would help increase productivity and improve competitiveness. Lending to the private sector is improving, but credit growth remains modest. While banks’ lending capacity is close to a historical high, their willingness to lend remains limited, especially to the corporate sector. Lending is also dampened by their sizeable amount of nonperforming loans. The central bank launched various schemes to promote lending to small firms, which picked up significantly in 2016. Lending to households also improved in 2016, as the new government housing support scheme and growing property prices started to spur households’ borrowing. However, overall credit growth is not yet strong enough to support economic growth. Fiscal policy has been prudent but the fiscal stance is expected to loosen, posing a risk for a medium-term debt reduction. The budget deficit decreased to a historical low of 1.6 % of GDP in 2015, but is forecast to rebound. The headline deficit is expected to have reached 1.8 % of GDP in 2016 and projected to rise further to 2.4 % in 2017 and 2.5 % in 2018, due to planned measures such as tax cuts and spending increases. Since its peak in 2011, the public debt ratio has declined continuously, helping improve Hungary’s financial stability. However, in the absence of fiscal adjustment, the deterioration of the structural balance may jeopardise the goal of steadily reducing debt in the medium term. Overall, Hungary has made limited progress in addressing the 2016 country-specific recommendations. Some progress has been made in reducing the tax wedge for low-income earners, but progress in reducing sector-specific taxes and improving transparency and competition in public procurement has been limited. The latter is to a large extent due to a delay in the development and implementation of e-procurement. Some progress has been made in facilitating the transition from the public works scheme to the primary labour market and reinforcing other active labour market policies. Limited progress has also been made in improving the adequacy and coverage of social and unemployment benefits; and educational outcomes and participation by disadvantaged groups, in particular Roma, in inclusive mainstream education. 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 expenditure and reduce early school leaving and poverty. The main findings of the analysis in this report, and the related policy challenges, are as follows: External balances continued to strengthen both in terms of stocks and flows. Net external liabilities declined from 116 % of GDP in 2009 to 61 % by 2015, and the ratio is estimated to have declined further in 2016. The economy has been rebalanced by maintaining large current and capital account surpluses, which reflect private sector debt reduction and a sizeable inflow of EU funds. The improvement in the external balance continued despite a pick-up in domestic demand, showing the strength of the underlying adjustment. Internal financial balances have also strengthened further. Hungary entered the crisis burdened with a relatively high level of private sector debt, mostly denominated in foreign currencies. The biggest systemic risk from this foreign currency exposure was removed by converting households’ foreign currency mortgages in recent years.

This helped reduce private sector debt from its peak 117 % of GDP in 2009 to 83.9 % by 2015. The banking system has also strengthened substantially in the past two years. The sector’s profitability has been helped by the improving economic environment and by a reduction in taxes on banks. The funding structure and capital position of Hungary’s banks are adequate. The biggest challenges are (i) the proper management of the decreasing but still sizeable amount of non-performing loans, (ii) restarting market lending, especially the corporate segment, and (iii) moving sustainable profitability levels towards regional averages. Low corporate investment is however holding back productivity growth and thereby competitiveness and potential growth. Productivity is comparatively low. Without productivity gains, there is a risk of Hungary becoming less competitive in the medium term. The recent increases in minimum wages are intended to trigger a shift towards higher productivity jobs. Innovation is not yet embedded in the economy reflected in wide productivity gaps between foreign-owned and domestic companies. Regulatory barriers in services, including retail, tend to limit market dynamics and hamper investment. Recent tax measures go in the right direction but challenges in the tax system remain. Hungary’s total tax-to-GDP ratio remains well above its regional peers’, though the 2017 cuts in social security contributions and corporate income tax have reduced the tax burden by some 1.5 pps., improving the country’s competitiveness. The tax wedge on labour costs is set to decrease gradually, but remains high for several groups, especially low-income workers without children. Despite a declining trend since 2013, sectorspecific taxes still tend to complicate the tax system and weaken investor confidence. The complexity of the tax system and associated administrative burdens pose a continuing challenge. While there is still room to improve the efficiency of tax collection and tax compliance, policy efforts to combat tax evasion and fraud have produced tangible results. Despite significant improvements, the Hungarian labour market still faces challenges. The main active labour market policy remains the public works scheme. The government is strengthening efforts to reinforce other active labour market policies. The system of childcare services has been reformed to tackle the persistently wide gender employment gap and the impact of parenthood on women's employment. Some poverty indicators have fallen back to pre-crisis levels, but remain high in comparison with other EU Member States. Poverty among children and Roma has declined, but remains at a high level and the adequacy and coverage of social assistance and unemployment benefits is still limited. Performance in providing basic skills remains weak by international standards and the impact of pupils’ socio-economic background on education outcomes is one of the highest in the EU. The concentration of disadvantaged pupils, in particular Roma, in certain schools is becoming more pronounced. Finally, labour market participation is affected by comparatively weak health outcomes and unequal access to healthcare. Weaknesses in institutional performance weigh on the business climate and reduce the growth potential of the economy. The unstable regulatory environment is one of the biggest barriers to doing business in Hungary, with insufficient stakeholder engagement and evidence-based policy making. The transparency and predictability of the budget process remain limited. Public procurement is still characterised by limited competition and transparency. Corruption risks remain high and there are notable gaps in the measures taken to address the issue. 1. Economic situation and outlook

GDP growth Following a strong performance in 2015, economic growth temporarily eased in Hungary, as EU-funded investments dipped. Stoppages in production in a major automotive company also added to the slowdown. Overall investment is estimated to have contracted by 9.6 % in 2016, following a 1.9 % growth in 2015. Despite this contraction, domestic demand growth remained dynamic, holding up GDP growth at 1.9 % in 2016, down from 3.1 % in 2015 (Graph 1.1). Private consumption grew by a robust 5.0 % supported by accelerating wage growth, growing employment and low inflation. Trade flows remained strong as net exports contributed 0.9 pps. to GDP in 2016. On the production side, an exceptionally good performance by agriculture is estimated to have generated an above-average contribution to GDP growth. Graph 1.1:Contributions to real GDP growth Source: DG ECFIN, Winter Forecast 2016 Economic growth is forecast to accelerate to 3.5 % in 2017 and 3.2 % in 2018. The dynamic growth in household consumption is projected to continue. This is supported by accelerating wage growth, consumer confidence at a post-crisis high, further positive developments in household lending and second-round effects following improvements in the housing market. However, employment growth, which boosted consumption until now, is expected to ease as the economy reaches full employment. After a significant fall in 2016, investment is forecast to progressively recover as of 2017. Real investment is expected to grow at around 10 % in 2017 and 5 % in 2018. This is mainly due to an increased absorption of EU funds, improving domestic demand prospects, increasing household investment and several large planned investments in the automotive sector. The low interest rate environment and a recovery in corporate lending are also expected to boost investment. Reflecting improved competitiveness, net exports boosted growth until 2016, but strengthening import demand is projected to gradually counterbalance this effect in 2017. This is mainly due to the expected pick-up in domestic demand, which will boost import growth towards 7 %. Exports are expected to continue to grow at a relatively stable rate, around 5.5 %. Hungary’s export market shares grew in the last 3 years (Graph 1.2) and the country’s exporters are expected to keep gaining market share in the near future. However, increasing unit labour costs will weigh on Hungary’s relative trade performance. Graph 1.2:Export market shares Source: Eurostat Hungary's unit labour costs (ULC) increased considerably in 2016. Nominal ULC grew by 5.1 % in 2016, which is 4 pps. above the EU average. This increase was mainly driven by dynamic wage growth, but also by a slight deterioration in productivity (Graph 1.3). Real ULC developments, however, appear stronger as Hungary’s real ULCs have been on a downward trend since 2010. Nevertheless, looking forward, real wage growth is forecast to significantly outpace productivity. This is expected to reduce price and cost competitiveness in the near future. Competitiveness is discussed in more detail in section 3.4. Graph 1.3:Unit labour cost developments in Hungary Source: Eurostat Inflation Inflation remained muted in 2016, but is forecast to gradually approach the central bank’s medium-term target of 3 % by 2018. Headline inflation has remained around zero since 2014 as falling energy prices fully offset limited inflation in services and food. However, core inflation, which excludes energy and unprocessed food prices, remained stable at around 1.3 %. Inflation is forecast to accelerate towards the Hungarian central bank’s target of 3.0 % by 2018. Price growth is expected to be broad based, as energy prices grow again and prices of services accelerate on the back of strong wage growth (Graph 1.4). Gross wages are forecast to grow by 8.7 % in 2017 and by 7.5 % in 2018. As labour shortages have already started to limit production – mainly in industry, construction and services – overheating risks are expected to appear, contributing to ‘demand-pull’ inflation. These risks are expected to be exacerbated by the projected fiscal loosening in 2017 and 2018, mainly linked to the minimum wage and tax reforms (Box 1.1). Graph 1.4:Contributions to HICP inflation Source: Commission's calculations based on Eurostat data, Winter Forecast 2016 Labour market The Hungarian labour market has improved in the recent years. The unemployment rate fell below 5 % in 2016. The employment rate has increased significantly since the recovery started in 2013, while activity rates have been steadily increasing since 2008 (Graph 1.5). Employment reached 4.4 million in 2016, supported also by the public works scheme, which employed approximately 220 000 persons on average in 2016. Private sector job creation amounted to around 130 000 in the same year. As a consequence, full-time equivalent employment in the domestic private sector has come close to the pre-crisis level. Rates of long-term and youth unemployment, as well as the rate of young people out of both employment and education/training, largely returned to their pre-crisis levels. There are however growing indications that the labour market is tightening. Employment growth is expected to slow in the coming years as labour supply becomes more limited. There are skill shortages in numerous sectors and it is increasingly difficult to match both the skilled and unskilled labour force with vacancies. Consequently, there is a significant pressure on wage growth, which is another indicator of tightening labour market. Graph 1.5:Activity, employment and unemployment Source: HCSO Social developments Inequality increased during the recovery but remains below the EU average. The S80/S20 indicator — which compares the proportion of the income of the richest 20% of households to that of the poorest 20% — increased from 3.4 in 2010 to 4.3 in 2015. This is well below the EU average of 5.2. The available data indicate that inequality in net wealth ( ) was within the range observed in other EU countries for which data were collected in 2013-2014 (ECB 2016). Market income inequality (before taxes, social transfers and benefits are taken into account) is close to the EU average. It is driven by increasing wage dispersion and faster wage growth by higher earners. While the benefit system is effective in reducing market inequality, the introduction of a flat tax in 2011 made the tax system less progressive, which has had a negative impact on inequality. A strong spatial dimension also plays a role, with the incomes of rural households at only 73 % of urban households. This figure is well below the EU average of 83 %. Inequality also exists in access to services, such as education and health care, negatively affecting in particular the Roma. Public finances The budget deficit decreased to historically low levels in recent years, but the fiscal stance is expected to loosen in the short term. After reaching 1.6 % of GDP in 2015, the headline deficit is expected to have increased to 1.8 in 2016 and forecast to rise further to 2.4 % in 2017 and then to 2.5 % in 2018. The country’s fiscal situation benefits from a tax-rich recovery, declining interest outlays, savings in social transfers and considerable temporary revenues. The increased fiscal leeway, however, is expected to be more than offset by deficit-increasing measures, including substantial tax cuts and spending increases. As a result, the structural deficit is estimated to deteriorate considerably, reaching around 3 ½ % of GDP in 2017 and 2018.

The public debt ratio continued on a declining path, helping to improve financial stability. Following the outbreak of the financial crisis, the government debt-to-GDP ratio increased sharply, reaching almost 81 % in 2011. Since then, it has decreased by more than 6 pps., falling below 75 % by 2015. The reduction of debt was supported by the takeover of the assets of mandatory private pension schemes (so-called second pillar), fiscal consolidation efforts and the subsequent economic recovery. Although the current public debt ratio is still well above that of regional peers, Hungary's sovereign financing risks have receded significantly. Looking ahead, the debt ratio is forecast to decrease further in 2017 and 2018. However, in the absence of fiscal measures, the deterioration of the structural balance points puts at risks the objective of ensuring a firmly declining debt-reduction path, towards the debt rule reference level of 60 % of GDP. Financial sector Financial sector assets have continued to contract, in line with further deleveraging in the private sector. Private debt was reduced to about 84 % of GDP in 2016, from its peak of close to 120 % of GDP in 2009. While credit flows remained negative for households, credit growth to non-financial corporations remained marginally positive (including inter-company loans and loans from foreign financial institutions, Graph 1.6). Credit growth remains limited by banks’ cautious lending strategies, especially to the corporate sector. The central bank launched various schemes to promote lending to small firms, which picked up significantly in 2016. Lending to households also started to improve in 2016, as the new government housing support scheme and growing property prices started to spur households’ interest in borrowing. Graph 1.6:Decomposition of credit flows Source: Eurostat The financial sector has yet to fully benefit from the improvement in macroeconomic conditions. Some encouraging signs appeared in 2016, such as improved profitability, strengthening capital positions, and a decrease in non-performing loans. A key measure for the return to profitability was a close to 50 % reduction in the bank levy in 2016. Improved profitability also led to strengthening capital positions. Prompted by regulation, financial institutions continued cleaning up their portfolios of non-performing loans. The financial sector is discussed in more detail in section 3.2. External position Hungary’s external position has continued to improve in terms of both stocks and flows. Net external liabilities declined to 61 % of GDP in 2015 (from 76 % in 2014 and the peak of 116 % in 2009). They are estimated to have declined further in 2016. The economy was rebalanced by maintaining high current and capital account surpluses. The latter reflect private sector deleveraging and a high inflow of EU funds. The external adjustment was helped by Hungary’s floating exchange rate regime, as the real depreciation of the forint helped improve the trade balance. Hungary’s strong net lending position remained stable over the last 4 years, despite the pick-up in domestic demand (Graph 1.7). Even though EU fund inflows temporarily declined in 2016, the country’s net lending remained high (at 6 % of GDP). It is projected to remain at this level in 2017 and 2018. Graph 1.7:Net lending / borrowing by institutional sector Source: Eurostat Real convergence & potential growth Despite an improving performance since 2013, Hungary’s real convergence still lags behind most of its regional peers (Graphs 1.8 and 1.9). Over a 20-year period, Hungary’s per capita GDP in terms of purchasing-power-parity (PPP) rose from half to two thirds of the EU average. The country started this period as the third highest per capita GDP among the emerging market economies in the central-eastern European region. By the end of the period, however, it had fallen back to the 7th position. While the convergence of most of its peers slowed after the 2008/09 crisis, Hungary’s convergence had already decelerated significantly before the crisis (Graph 1.9). Graph 1.8:Per capita GDP in PPP terms Source: Eurostat Graph 1.9:Average annual rate of real convergence Source: Commission's calculation based on Eurostat data Graph 1.10:Contributions to potential growth Source: DG ECFIN, Winter Forecast 2016 Potential growth recovered, but similar to most of its regional peers, it still lags behind the pre-crisis years. Potential growth in 2016 is estimated at 2 %, which is more than 1 pp. below Hungary's pre-crisis average (2000-2008). While potential growth was driven by total factor productivity before the crisis, this factor disappeared thereafter. The post-crisis recovery was labour-intensive, which is also reflected in a growing labour contribution to potential growth. The key to elevated potential growth lies in enhancing total factor productivity, based on well-designed structural policies (section 3.4).

Table 1.1:Key economic, financial & social indicators — Hungary Source: European Commission, ECB

2. Progress with country-specific recommendations Progress implementing the 2016 ( ) recommendations for Hungary has to be seen in a longer term perspective (since the introduction of the European Semester in 2011). Over the six year period recommendations have focused on the issues of public finances, taxation, the labour market and the business environment. Over the 2011-2016 period the government has achieved considerable progress with strengthening public finances. Structural reform measures were included in the 2011 Convergence Programme and further saving measures were adopted as part of the 2012 budget. Moreover, a new package of consolidation steps, concentrating mainly on the revenue side, was announced in the 2012 Convergence Programme with the ambition to attain the deficit targets in 2012 and 2013. In June 2013, the Council of the European Union decided to abrogate the decision on the existence of an excessive deficit in Hungary. Recommendations regarding labour taxation, active labour market policies and social assistance have been adopted every year since 2011. In recent years the authorities have implemented several measures to reduce the tax wedge, especially tax credits for families and targeted social security contribution cuts for selected groups and have achieved some progress. However, the Hungarian tax wedge remains high in international comparison, especially for low income earners.Similarly, some progress can be observed regarding active labour market policies. For years, the authorities' main focus was the public works scheme with growing number of participants; however, its efficiency was limited. Recently the expansion of the scheme halted and no further increase of the budgeted amount is expected. In fact the number of the public workers started to decline reflecting improving labour market conditions. Further activation measures were adopted such as the reimbursement of travel costs. The recent increase of the minimum wage also may further encourage public workers to enter the open labour market. A number of programmes have recently been launched with the support of the European Social Fund (ESF) and the Youth Employment Initiative (YEI). (see Section 3.3). A third area of recommendations has been centred on barriers to business. Hungary has received a recommendation in this area every year since the European Semester started. Recommendations cover several fields including high administrative burdens; public procurement; the legislative process; competition; a stable regulatory environment; tax compliance costs and supporting the SME sector. Several measures were developed in response. For example the Funding for Growth Scheme, a program of the Central Bank helped SMEs by subsidised loans. Another very successful measure was linking cash registers online to the tax authority. Between 2013 and 2015 Hungary received yearly recommendations to take measures to restore lending to the real economy. This included reducing burdens on banks and decreasing state ownership in the banking sector. In 2015, the Hungarian authorities announced their plans to reduce the financial burden on banks. This was emphasised in a memorandum of understanding signed with the European Bank for Reconstruction and Development. The government committed itself to gradually reduce bank taxes, to reprivatise two commercial banks recently acquired by the Hungarian state, and to assist in reducing non-performing loans. It also committed to refrain from implementing new laws or measures with potential negative impact on the profitability of the banking sector. 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, gradually reducing its imbalances. External imbalances had been significantly reduced and the public debt ratio declined since the beginning of the decade. The indicators of net international investment position had rapidly improved. The country also repaid its debt under the 2008 balance of payment assistant programme. Overall, Hungary has made limited progress in addressing the 2016 country-specific recommendations (Table 2.1). Some progress has been made in reducing the tax wedge for low-income earners, but progress in reducing sector specific taxes and strengthening transparency and competition in public procurement has been limited. The latter is to a large extent due to a delay in the development and implementation of e-procurement. On the regulatory environment in the services and retail sector, no progress has been achieved. Regarding labour market, education and social policies (CSR3), some progress has been made in introducing incentives towards supporting the transition from the Public Work Scheme to the primary labour market and reinforcing other active labour market policies. Limited progress has also been made in improving the adequacy and coverage of social assistance and unemployment benefits, as well as in increasing the participation of disadvantaged groups, in particular Roma, in inclusive mainstream education. Table 2.1:Summary Table in 2016 CSR assessment Source: European Commission 3. Reform priorities 3.1. Public finances Taxation The government has introduced new reforms to tackle the persistently high overall tax burden in Hungary. The total tax-to-GDP ratio hovered around 38-39 % in recent years, which was the highest among the country's peers at a similar level of development. There have been marked improvements in tax composition. The weight of direct taxes declined significantly (by 7 pps.) over the past ten years, along with a parallel increase in the share of indirect taxes. This shift mainly reflected the phasing-in of a new flat rate personal income tax regime. Nevertheless, the tax burden on labour income still remained substantial on account of high social security contributions. Systemic changes also included the introduction of some relatively distortive forms of taxation such as sector-specific levies. The government's most recent tax package of November 2016 aims at reducing the overall tax burden, while also lowering the tax wedge on labour.

Despite some recent improvements, sector-specific taxes still play a prominent role, weighing on the business environment. The introduction of these taxes was motivated by the goal to increase tax proceeds from areas where profitability was perceived to be high. Revenues from sector-specific taxes were estimated at about 1.5 % of GDP in 2016, including banking, insurance, utilities, energy, telecommunication and retail sectors. The decline from the peak in 2013 (close to 2 % of GDP) reflects in particular the halving of the banking tax in 2016. However, apart from an additional marginal decrease in taxes on the banking sector, no further reductions in sector-specific taxes are implemented in 2017. These surcharges are usually based on turnover or assets and in some cases involve progressive rates. As a consequence, intermediate goods and services are also part of the tax base, which results in a distortionary effect. Given that many of the sectorial levies could not be fully passed on to customers, they also decrease the rate of return to investment (Deloitte, 2015). Even though the magnitude of the direct distortive effects may differ, the presence of selective extra taxes itself creates regulatory unpredictability, weighing on investor confidence. The general corporate income tax rate was lowered markedly from 2017 onwards, mostly benefiting large companies. The new tax rate of 9 % has replaced the previous scheme of 10 %, increasing to 19 % above a particular threshold. The reduction thus benefits mostly larger companies, especially those that had fewer opportunities to use the available extensive tax allowances. The lowest corporate income tax rate in the EU will improve Hungary's competiveness, but could make it more attractive for tax optimisation purposes by foreign companies. At the same time, the overall tax regime for companies remains complex. Sector-specific taxes and other smaller taxes on enterprises are bigger sources of tax revenue than the standard corporate income tax. The high tax wedge on labour, particularly for low-income earners, can negatively affect the employability of low productivity workers and hamper investment. In 2015, the last year with comparable figures, Hungary belonged to the group of countries with the highest tax burden for several taxpayer categories. In particular, Hungary had the highest tax wedge within the EU for single earners earning 50 % of the average wage; the second highest at 67 % of the average wage and the fourth highest at the average wage. A number of measures adopted before 2016 reduced the tax wedge for targeted groups, but these had a limited effect on low earners overall. Family tax credits reduce the tax wedge for low-earners with children. However, even for these household types, the tax wedge remains above the EU average, especially for families with less than three children at low incomes. Targeted social security allowances, introduced under the Job Protection Act (JPA) in 2013, reduce the tax wedge for several groups such as unskilled workers, certain age groups or carrier starters. However, the estimated effect of such allowances – 3.5 pps. in 2016 for a typical beneficiary earning 67 % of the average wage – has not substantially changed Hungary's comparative position (see Graph 3.1.1). Measures adopted since 2013 include the lowering of the flat personal income tax rate by 1 pp. and the further extension of the family tax credit. Graph 3.1.1:Tax wedge of a single worker earning 67% of average wage Source: OECD and European Commission calculations. In autumn 2016, the Government launched a major multiannual reform package, which reduces the tax wedge for low-wage earners as well. Employers' social security contributions are set to decrease by 5 pps. in 2017, and by a further 2 pps. in 2018. For single earners at 67 % of the average wage, the measure is estimated to reduce the tax wedge by 2 pps. in 2017, and then by around 1 pp. in 2018, reaching a level just above 45 %. For workers eligible for the contribution allowances under the JPA, the reduction will be lower as the targeted allowances were also cut in a parallel measure. Their tax wedge is calculated to decline from 45 % in 2016 to about 43 % by 2018 (Graph 3.1.1). Despite the noticeable reduction, the tax wedge for low-income earners without children will remain considerably higher than the EU average of 37 %. By contrast, for households with two children, the reduction in the tax wedge is more substantial due to an on-going increase of the family tax credit. As a consequence, for this household category, the tax wedge will be close to the EU average by 2018.( ) With the simultaneous increases in the minimum wage, the net impact of the package is likely to be an increase in total labour costs regarding workers at low-income levels, at least in the short term. Growth friendly taxes such as environmental or property taxes play a relatively moderate role. The tax system is already strongly reliant on consumption taxes with the highest standard VAT rate (27 %) in the EU. At the same time, studies show there is potential to increase the reliance on environmental taxes (including vehicle and pesticides taxes or congestion charges) (Eunomia, 2016). The effective excise rates on unleaded petrol and diesel are among the lowest within the EU (European Commission, 2016a). Finally, the level of recurrent property taxes is also low (0.6 % of GDP), well below the EU average. The recovery of the property market seems to provide better conditions for shifting taxes towards property. The complexity of the tax system generates important administrative and compliance costs. The time and costs required to meet tax obligations are higher than in most neighbouring and OECD countries (World Bank, 2017). High compliance costs weigh in particular on SMEs. The simplified regimes KATA (small business lump sum tax) and KIVA (small business tax) aim at reducing the administrative burden on SMEs. The costs of administering taxes are estimated to be ten times higher for these firms than for larger companies (OECD, 2016a). The tax system includes a multitude of small taxes generating only minimal proceeds. Sector-specific taxes also add to the complexity of the system. Several goods and services are subject to more than one levy, often using different tax bases. Tax policies are still subject to sudden changes imposing adjustment and transaction costs on businesses. The government has recently announced a comprehensive review in order to reduce the administrative burdens of taxation and to simplify the tax structure. Measures to combat tax avoidance and fraud have significantly contributed to more effective tax collection. Recent policy initiatives such as the introduction of online cash registers in retail and the Electronic Public Road Trade Control System (EKAER) have produced visible results.( ) The VAT gap, which shows the magnitude of tax avoidance, decreased sharply, by 4 pps. to 18 % in 2014, although it still remains above the EU average (14 %) (European Commission, 2016b). The 2017 budget counts on sizeable yields from curbing tax evasion with the help of additional measures. These include a further extension of online cashiers to services and introducing online invoicing for inter-company transactions. Public debt sustainability The government debt-to-GDP ratio has been steadily declining since the beginning of the decade. The pace of debt reduction received an impetus from the takeover of mandatory private pension assets by the State. In parallel, the primary deficit turned to a surplus (of around 2 % of GDP between 2012 and 2015). More recently, debt reduction benefited also from a favourable "snowball" effect (i.e. the combined effect of growth rate and interest) thanks to economic recovery and declining interest rates. The debt ratio is expected to decrease further from 74.7 % in 2015 to around 71% by 2018. However, the structural primary balance is forecast to move into deficit (of -1.0 % of GDP in 2018) reflecting the estimated widening of the positive output gap. This poses some risk for Hungary's debt reduction path. Public debt is still high for a middle-income economy, but sovereign financing risks have been considerably reduced since the crisis years. On the basis of the Commission's short-term risk indicator, the country faces a low risk of an immediate fiscal distress. This is also confirmed by the recent upgrades of the country's sovereign risk ratings. The maturity structure of debt has improved. The initially high proportion of foreign exchange-denominated public debt has been decreasing, supported by the central bank's self-financing programme. Graph 3.1.2:Gross government debt ratio: the baseline scenario and alternative trajectories Source: European Commission calculations The debt ratio is projected not to remain on a decreasing path in the medium term, starting to increase again at the end of this decade. Based on the Commission's no-policy-change baseline scenario, government debt is projected to rebound to around 74.5 % of GDP by 2027, i.e. to the level seen in 2015 (Graph 3.2). The debt trajectory benefits from the estimated decrease in age-related public spending reflecting the impact of recent parametric pension reforms. However, this effect is projected to be more than offset by the deterioration of the underlying primary balance to its structural level and the negative effect related to the country's moderate potential growth coupled with the assumed rebound of interest rates. Overall, Hungary's medium-term debt trajectory has flattened markedly compared to a similar projection presented in the last year's Country Report (European Commission, 2016c). Apart from the forecast deterioration of the primary balance, this reflects the adverse impact of the wide positive output gap estimated for 2018, the year serving as the initial position for the medium-term projection ( ). The level of the output gap, however, is subject to considerable estimation uncertainty. Therefore the projection results should be treated with caution. The Commission's medium-term debt projection highlights the risks to the goal of placing Hungary's public debt firmly on a declining path. The primary balance forecast by the Commission on a no-policy-change basis for 2018 is significantly below the planned level in the latest Convergence Programme (by almost 1 % of GDP). If the fiscal trajectory remains in line with the plans in the Convergence Program up to 2020, the debt ratio would decrease relatively fast towards the 60 % of GDP benchmark level (Graph 3.2). However, there are negative risks to the medium-term fiscal plans. Without offsetting measures, the planned "Paks II." nuclear power plant project is estimated to result in a considerable debt increasing effect (European Commission, 2015a; Romhányi, 2014). Unless their performance is improved, the expanding role of state-owned companies, especially in the loss-making regulated energy sector, can increase contingent liability risks (see section 3.5). Hungary appears to face medium level debt sustainability risks. The country's medium-term sustainability gap referred to as the S1 indicator is currently estimated at 1.5 % of GDP. This shows the required fiscal adjustment, which would need to be achieved during the next five years in order to bring down the debt ratio to 60 % by 2031. At the same time, the long-term sustainability gap S2 is at 3.3 % of GDP. This is the sufficient upfront adjustment ensuring that the debt ratio would not move on an ever-increasing path in the long term. About one half of the adjustment need reflects the projected rebound in age-related public expenditure after 2030 (European Commission, 2015b). Fiscal framework Despite a solid fiscal performance, there are still weaknesses in Hungary's fiscal governance framework. The repeated overachievement of the deficit targets and the steady reduction of the public debt ratio reflected conservative planning. It also evidenced a strong policy commitment to intervene with corrective steps in case of an emerging slippage. The adopted improvements in the fiscal framework, most notably strict rules of debt control across all layers of general government, also contributed to the observed fiscal discipline. However, some noteworthy gaps still remain in the fiscal framework. The medium-term budgetary framework has not yet had its desired effect of making the budgetary process more transparent and predictable. The medium-term framework was adopted in 2013. A key feature of this planning mechanism is that differences between plans and the draft budget must be formally justified by the government. The first medium-term resolution was issued only in December 2015. It detailed expenditure and revenue plans for budgetary chapters over a two-year period. The deliberation of the 2017 budget therefore served as a test case for the new framework. For several budgetary chapters, the differences between appropriations and the respective medium-term figures were sizeable (at 0.5 %-1 % of GDP), although this was only four months after the publication of the resolution. The written justifications for the differences were often unavailable. Moreover, the medium-term plans were not based on the most appropriate information, since some explanations explicitly referred to decisions taken already in autumn 2015. Domestic numerical rules are an imperfect guide for budgetary policy. While the overall objective of debt sustainability is underpinned by constitutional provisions, there are some design weaknesses in the way it has been implemented through numerical fiscal rules. The debt reduction formula does not provide an effective constraint in practice due to a very broad escape clause introduced in 2015. The nominal and structural budget balance rules are binding only for the draft budget. However, they do not apply for the budget law as adopted by Parliament and for the budgetary execution stage.

The role of the Fiscal Council in scrutinizing and shaping fiscal policies remains weak. The Fiscal Council has continued to increase the number of published external studies. However, this has not been sufficient to ensure a strong analytical basis commensurate with the Council's uniquely strong constitutional veto power over the budget. The Fiscal Council focuses rather narrowly on the budget bill and its amendments, whereas there have been several examples of significant fiscal decisions and policy initiatives outside the annual budget cycle. This highlights the importance of systematically evaluating fiscal policies throughout the entire year. 3.2. Financial sector The Hungarian banking system has strengthened substantially over the past two years (Table 3.2.1). The funding structure and capital position of banks are adequate. Following several years of deleveraging, the banking system is mainly deposit-funded – customer deposits accounted for 57 % of the banks’ total liabilities at the end of 2015. The loan-to-deposit ratio was 80.9 %. The full conversion of the large foreign currency-denominated loan book (in 2014 and 2015) into Hungarian forint reduced both foreign exchange funding needs and short term refinancing risks. The shock-absorption capacity of the banking system remains strong. Capital adequacy at system level amounts to 20 % while Tier 1 eligible capital represents close to 14 %. In the stress test scenario designed by the Hungarian central bank, banks’ solvency levels seemed sufficient both at sector and individual bank level. Liquidity reserves in stressed conditions are adequate, though some banks move away from the regulatory minimum after the theoretical shock. Table 3.2.1:Financial soundness indicators, all banks Source: ECB, CBD Bank profitability has been improving but still lies below that of regional peers. Before 2015, the authorities had implemented a number of measures with largely negative effects on the banking system’s profitability. These included the highest bank tax in the EU, a financial transaction tax and a set of bills to help mortgage borrowers. Since 2015, the authorities have announced a number of policy measures to support the domestic financial sector, including a reduced bank levy (from 0.53 % to 0.24 % in 2016, and to 0.21 % in 2017 and 2018). The first levy reduction was already reflected in the positive 2016 profitability data, after breaking even in 2015. However, Hungary still lags behind regional peers, who recorded an average profitability of 6.7 % in 2015. Profitability in 2016 was also driven by the stabilised environment. Yet, much of the 2016 profits derive from the reversal of past provisions for expected losses. A sustainable rise in profits would be possible only when interest rates start rising again. Graph 3.2.1:Non-performing loans, 90-day+ ratios Source: MNB Graph 3.2.2:Net NPLs to own funds (%) Source: ECB (consolidated banking data) Although declining, the level of non-performing loans (NPL) remains high. The NPL ratio peaked in 2014 (Graph 3.2.1). Following the conversion of foreign-currency mortgages and a pick-up in economic growth, also reflected in real estate valuations, banks’ asset quality has been gradually improving. NPL ratios stood at 16.9% and 7.1% in the retail and corporate sectors respectively in the first half of 2016. Although the absolute level is still high in comparison to other Member States, they are well provisioned (coverage ratio of 63.4 % in June 2016). The loss absorbing capacity and the remaining spill-over risks to the sector are comparatively limited as net NPLs to own funds represented 43.6 % in June 2016 (Graph 3.2.2). Measures have been taken to address bad household debt. Delinquency rates are high among household mortgage borrowers (close to a quarter of mortgages are classified as NPL). The Hungarian Asset Management Company, with capacity to purchase a total of 35 000 dwellings, is targeting non-performing debtors in the most difficult financial situation. Mortgage holders who are excessively indebted can also initiate a debt settlement procedure under the Personal Bankruptcy Act adopted in 2015. Debtors have in general improved cooperation with lenders. This was helped by a recommendation issued to credit institutions by the central bank. The latter determined the expected minimum framework of cooperation between debtors and creditors. Important steps were also taken to tackle non-performing corporate loans. The asset management company established by the central bank (MARK) officially started operating in 2016. It aims to tackle the sizeable number of distressed commercial real estate loans and more generally to initiate the clean-up of banks’ balance sheets by selling their non-performing portfolios on the market. The central bank is also working on a new recommendation which will set out best practice guidelines on out-of-court restructuring and consensual settlement of NPLs in the corporate sector. The recommendation is designed to encourage lenders to adopt a more cooperative and coordinated approach where more than one financial creditor is involved. It could become an important tool for resolving such loans and improve the depth of the market for distressed assets in Hungary. Lending to the private sector is improving but both lenders and borrowers remain cautious. The recent trend in bank lending to the private sector is positive (Graph 3.2.3). The domestic banking sector’s lending capacity is close to a record high. Yet, willingness to lend is only gradually improving (Graph 3.2.4). Households and businesses also remain cautious about taking on new debt. In 2015, lending to the corporate segment decreased by 4.3 %, while household loans dropped by 5.8 % (excluding the effect of the legal settlement of household mortgage loans). Graph 3.2.3:Growth rate of outstanding loans Source: MNB Graph 3.2.4:Lending conditions in the corporate sector Source: MNB In 2016, several factors led to a gradual increase in appetite for borrowing. On the supply side, competition between lenders and lending conditions improved. On the demand side, wages and home prices rose, also supported by the Home Purchase Subsidy scheme (Box 3.2.1). The volume of new household loans grew by 38 % in 2016. Yet the total value of outstanding household loans declined by 4.5 % as repayments outgrew new lending. Growth of domestic corporate loans turned positive in 2016 but remained restrained due to firms’ still large self-financing capacity and frequent use of cross-border loans. In addition, confidence surveys indicate that borrowers are conservative about longer-term investments. This is partly due to the high dependency on EU funds (more details in section 3.4). Policy initiatives to boost small business financing start to bear fruits in loan growth. The Funding for Growth Scheme (European Commission 2015a and 2016c) was substituted by the new Market-Based Lending Scheme designed to boost SME financing. It provides interest rate swaps to participating banks, which cover part of the interest rate risks generated by new loans. In the first half of 2016, loan growth in the SME segment was up by 5 % y-o-y. At the same time, aggregate net lending to Hungarian firms increased by 0.3 %. Hungary announced a number of macro-prudential measures in 2016, which should further improve financial stability. The Hungarian central bank (MNB) identified nine systemically important financial institutions and introduced relevant risk buffers, applicable from 2017. It also announced its intention to introduce institution-specific systemic risk buffers linked to the risk of their commercial real estate NPLs. Hungary has a minimum foreign exchange funding adequacy ratio in place, which requires banks to hold a sufficient amount of stable foreign currency funds in proportion to their foreign currency assets. In addition, there is also a foreign exchange coverage ratio, which imposes a limit on the degree of currency mismatches between assets and liabilities.

The National Bank has expanded its area of action beyond monetary policy and purchased the Budapest Stock Exchange (BSE). The latter was nationalised in 2015 when the MNB purchased 68.8 % of the BSE from Austrian stakeholders. The BSE then adopted a new strategy to boost capital market access, growth, liquidity and improve the financial culture in Hungary. The BSE aims to become an alternative to bank financing for local companies. The new BSE management aims to reach market capitalisation of 30 % GDP, build a market for small firms with at least 30 participants, and attract at least 5 stock market launches (IPOs) a year. 3.3. Labour market, education and social policies LABOUR MARKET The Hungarian labour market has improved significantly since the recovery started in 2013 but still faces challenges. While unemployment has significantly decreased for all skill groups, it is still high for low-skilled workers. There are major disparities in labour market outcomes across high, medium and low-skilled workers. These have fallen significantly in the last five years, but remain high in 2015 (Graph 3.3.1). One reason for such disparities may be the high tax burden on low wages. In this regard, new measures lowered the tax wedge introduced in January 2017 will reduce tax/social security contributions (see Section 3.1). At the same time, surveys reported that businesses in certain sectors face increasing labour shortages. According to the European Business Survey, the share of firms in industry reporting that labour is a ‘factor limiting production’ has increased significantly since 2013 (surpassing 50 % in 2016) and is now the highest in the EU. Labour productivity growth has been weak in recent years (see Section 3.4). Low participation in adult learning as well as insufficient support via active labour market policies may contribute to skills mismatches and low productivity growth. The employment rates of older workers and people with disabilities are very low and the duration of working life is one of the shortest in the EU. ( ) Recent wage developments are symptomatic of a tightening labour market. Wage growth accelerated in 2015 and especially in 2016, indicating an increasingly tight labour market (National Bank of Hungary, 2016b, p. 30-33). In 2016, wages are projected to have increased faster than expected, due to inflation, productivity and unemployment developments (update of the original calculations by Arpaia and Kiss, 2015, see also section 1.). Graph 3.3.1:Relative dispersion of employment rates by education level, 2010, 2014 and 2015 Source: Update of calculations by European Commission (2013) and Kiss and Vandeplas (2015). European Commission calculations based on Eurostat data. A significant increase in the minimum wage is being introduced in 2017 and 2018. In November 2016 the government reached an agreement with social partners to increase the minimum wage by 15 % in 2017 and an additional 8 % in 2018 (see details in Box 1.1). Increases in the minimum wage have the potential to reduce in-work poverty and reduce wage inequality. At the same time, available evidence about past minimum wage increases in Hungary points to a small negative effect on employment in the small enterprise sector (5 to 20 employees). There is also evidence of adverse effects on the job-loss and job-finding probabilities of low-wage workers in the short run (Kertesi and Köllő, 2003; 2004). Possible negative effects may be counterbalanced to some extent by the reduction in employers’ social security contributions and ongoing labour market dynamics (see sections 1, 3.1 and 3.4). Measures aiming to improve the transition from the public works scheme to the open labour market are being worked out. The public works scheme (PWS) is the largest active labour market policy measure (ALMP) in Hungary (for over 200 000 participants, around 5 % of the labour force). Yet, despite some improvement recently, its effectiveness in facilitating transitions to the open labour market continues to be limited. According to the data compiled by the Ministry of Interior, the rate of successful exit from the scheme was 12.2 % in 2015 and 14.5 % during the first five months of 2016. The aim of the authorities is to decrease gradually the spending on public works and to increase the budget allocation for other ALMPs in the coming years. This is already visible in 2017: after having increased significantly in the past years, the budgetary allocation for public works is set to stabilize broadly. In recent years, the authorities adopted a set of measures to facilitate the transition from the PWS to the primary labour market; including financial incentives and enhanced training (see European Commission, 2016c). As of January 2017 further activation measures were introduced, such as the reimbursement of travel costs or the increased gap ( ) between the minimum wage and the public employment wage which may incentivise transitions to the open labour market, The authorities are considering a more ambitious set of measures but details are not yet available. Other active labour market policies are also being reinforced, partly with the support of EU funds. Planned spending on ALMPs is to be increased in 2017. A number of programmes have recently been launched with the support of the European Social Fund (ESF) and the Youth Employment Initiative (YEI). Since 2015 two large scale programmes exist. They aim to improve the employability and supporting the labour market entry for jobseekers and inactive people. Smaller programmes provide supplementary support. More than 34 000 PWS participants received ESF co-financed training in 2016, and a mentoring service has been introduced to improve efficiency. The profiling system for the unemployed is operational. As required in the YEI and other ESF programmes the compulsory use of Individual Action Plans has recently been extended to all jobseekers. However, the public employment service faces organisational and staff capacity constraints that might not allow for the intensive use of face-to-face meetings or personalised counselling. The childcare services system has been reformed to tackle the still high impact of parenthood on women's employment. While the employment rate for men reached 75.9 % in 2015, the rate for women stood at 62.1 % - a gap that has increased in recent years. The employment rate of mothers with young children is particularly low (14.8 % for women with children below three, and 39.4 % for women with children below six in 2015). This makes the impact of parenthood on women’s employment one of the highest in the EU. In previous years, the gender employment gap could mainly be explained by long parental leave benefits and a lack of childcare services. Enrolment in formal childcare for children aged 0 to 3 is 15%, well below the EU average of 28 %. From January 2017, new forms of childcare facilities have been introduced and a capacity increase has been announced ( ). The rate of women not in the labour market due to caring responsibilities is 26.5 % compared to the EU average of 18.7 %. Support schemes for people with dependent relatives are underdeveloped. Furthermore, there is a significant inactivity trap for second earners. ( ) The gender gap in employment is especially high among Roma, with only 26 % of Roma women in employment, compared to 45 % of men (Fundamental Rights Agency, 2016). ( ) The participation of social partners in policy making is limited. Since the 2011 reforms, social dialogue lacks a formal feedback mechanism for government proposals regarding employment and social policies. Tripartite negotiations are mostly limited to the minimum wage and wage increase recommendations. SOCIAL INCLUSION & POVERTY Some poverty indicators are back to pre-crisis levels but remain high relative to the rest of the EU. After a significant increase in poverty between 2008 and 2013, the situation has improved as the labour market started to recover (Graph 3.3.2). The rate of people at risk of poverty or social exclusion (AROPE) fell to 28.2 % in 2015 ( ), close to pre-crisis levels. It is nevertheless still among the ten highest in the EU. In 2015 severe material deprivation fell by 4.6 pps. but at 19.4 % it was still more than twice the EU average (8.1 %). Severe housing deprivation among the poor and in particular among children living in poverty is still high while the social housing stocks are very narrow: only 3 % of the total housing stocks, concentrated mainly in big cities. In-work poverty increased significantly, reaching 9.3 % in 2015, close to the EU average of 9.5 % although the minimum wage increase will likely improve the situation. Graph 3.3.2:Main poverty indicators, 2005-2015 Notes: AROPE: "At-risk-of-poverty or social exclusion" rate (% of total population). People who are "at-risk-of poverty" (AROP) and/or suffering from severe material deprivation (SMD). AROP: At-risk-of poverty rate (% of total population), i.e. people who have an equivalised disposable income below 60% of the national equalised median income. Source: Eurostat, EU-SILC [ilc_peps01, ilc_li02, ilc_mddd11, ilc_lvhl11] Poverty among children and Roma is also declining but remains particularly high. Despite a significant decrease since 2013, 36.1 % of children were still at risk of poverty or social exclusion in 2015, above the EU average of 26.9 %. Improved access to childcare services will help decrease child poverty further. The at-risk-of-poverty rate for Roma is almost five times higher than for non-Roma, according to various statistics ( ). This rate is comparable with other Member States with a sizable Roma minority (BG, CZ, SK, RO) where the rate of poverty for Roma is estimated to be between three to more than six times higher than for the general population (FRA, 2016). According to Hungarian data around two thirds of Roma suffer from severe material deprivation. ( ) This is linked to the high residential concentration of Roma in areas characterised by lack of access to drinking water (29 %) and basic amenities (43 %), which remain high in regional comparison, further worsening their living conditions (FRA, 2016) The employment of Roma is one of the highest in the EU (36%, FRA 2016), but a significant proportion (41.6 %) of Roma in employment work in the public works scheme. Their effective integration in the open labour market thus remains so far limited. The adequacy and coverage of social assistance and unemployment benefits is limited. The duration of unemployment benefits is still the lowest in the EU at 3 months (see European Commission, 2016c). The impact of social transfers (other than pensions) in reducing poverty has been declining since 2008, falling to 42 % in 2015, but it remains higher than the EU average. The nominal level of three types of targeted cash benefits increase slightly in 2017, while the minimum income benefit remains unchanged. The 2015 social assistance reform streamlined the benefits system but it does not yet seem to have guaranteed a uniform and minimally adequate living standard for those in need. Studies suggest that the majority of entitlements remain in place, albeit with a high degree of discretion in the eligibility criteria for the benefits administered by municipalities (Mózer, 2016). Public works play a significant role in social policy, particularly in disadvantaged areas of the country. But in those areas it may create a risk of benefit dependency and an inactivity trap for social assistance beneficiaries who tend to transit between living on benefits and participating in public works. EDUCATION AND SKILLS The 2015 PISA survey of educational systems showed significantly worsening results for Hungary and a very high impact of the socio-economic status on students’ performance. Performance in reading and science worsened significantly compared to 2012. Results remained stable, but low, in mathematics. Hungary saw the one of the highest increase in the EU in the share of low achievers in science. The impact of pupils' socio-economic background on education outcomes is one of the highest in the EU. Also the impact of the school type on education outcomes is very significant. Pupils are tracked into different schools according to their performance starting from the age of 10. This leads to significant variations in performance by school type. The choice of school type is in turn heavily influenced by the parents’ socioeconomic background (Education Authority, 2016a, 2016b). PISA performance was above the OECD-average in general upper secondary schools. It was below the OECD-average in vocational secondary schools and much lower in vocational schools. The reduction of teaching hours of science subjects in vocational grammar schools since 2016 is likely to amplify Hungary’s bottleneck in science skills. The share of early school leavers remained stable in 2016, but varied widely by region and school type. The percentage of early school leavers stood at 11.6% in 2015, close to the EU average, but unlike the latter it has not fallen in the last five years. The level varies by region, with the highest rates in the north-east of the country, the region most affected by poverty. Despite some improvement since 2011, early school leaving remains particularly high among Roma at 59.9% compared with 8.9 % among non-Roma. ( ) Only 28% of Roma in upper secondary education attend school at the level corresponding to their age (FRA 2016). 46.9% of all early school leavers drop out of vocational schools, 33% from vocational upper secondary schools and 12.9% from general upper secondary schools (Fehérvári, 2015). The decision to lower the compulsory age for participation in early childhood education and care from five to three years was a positive step, as evidence shows that in all countries the share of low achievers is smaller among students who participated in pre-primary education. The Roma participation in early childhood education is one of the highest. However, there is no monitoring system for young people who have already dropped out of school with a view to re-integrate them into society and the labour market.

The distribution of disadvantaged pupils between schools is uneven. As highlighted in the 2016 Country Report, national data indicates growing school segregation, calculated on the basis of possible contacts between disadvantaged and non-disadvantaged pupils in primary schools (Hungarian Academy of Sciences, 2015). This development has also an ethnic dimension: national and European surveys indicate that increasing shares of Roma children attend Roma-majority schools and classes. This phenomenon can be partially explained by the higher concentration of Roma population in certain parts of the country. However, separate education exists not only in remote settlements, but also in towns with several schools, which also reflects parental choice (Kertesi–Kézdi, 2013). ( ) Legislative changes aiming to prevent segregation have been tabled, but remain to be adopted and implemented. Some specific measures ( ) supporting teacher training, early education, school achievement and fighting early school-leaving of Roma are in place. However, comprehensive and system-level measures to address segregation are lacking. Teachers’ salaries have increased since 2013, but they remain low. They correspond to around 71% of the salaries of other tertiary graduates (OECD, 2016, p. 422). Despite an increase in enrolments for teacher training in recent years, the number of teacher training applicants is still insufficient to replace retiring teachers, in particular in science subjects, despite dedicated scholarships for trainee teachers to address the shortage of teachers. More generally, following a decrease in the previous three years, public expenditure in education increased by 12.5 % in 2014. The growing demand for highly-skilled workforce is not matched by a sufficiently large pool of applicants to tertiary education and adequate completion rates. Hungary’s tertiary educational attainment rate for 30 to 34 year-olds stood at 34.3% in 2015. The rate was thus in line with the EU2020 national target of 34%, but below the EU average (38.7%). There has been a decline in applications and enrolment rates for tertiary programmes since 2011 but the drop-out rate from higher education is higher ( ). This may negatively affect tertiary attainment rates in Hungary over the next decade. The low relative number of researchers and tertiary graduates is considered to be one of the main challenges of the Hungarian research and innovation system (European Commission, 2016d). A recent reform has changed the structure of vocational education and training. The different secondary school types were renamed in 2016 with the intention to make vocational education more attractive. However, the revised curricula seem unlikely to lead to an improvement in basic skills and competencies (see also European Commission 2015a, 2016c). The proportion of VET students in work-based learning is one of the highest in Europe (about 70%). Adult participation in life-long learning has increased but remains below the EU average (7.1% in 2015 vs 10.7%). HEALTHCARE Public expenditure on health is low in Hungary, by EU standards. The share of public expenditure on health was 67.1 % in 2014 (EU average 76.2 %). Public current expenditure on health as a share of GDP was also below the EU average in 2014 and has not increased since 2000. The goals of the Healthy Hungary 2014-2020 Strategy are unlikely to be attained without increased strategic investment in the health care sector. At present, weaknesses in care coordination and the lack of incentives to provide definitive care lead to a high number of referrals to specialists and hospitals, which has implications on the cost-effectiveness of the system (European Commission and Economic Policy Committee, 2016). Hungary shows weak health outcomes, with negative implications for labour market participation. Despite recent improvements, life expectancy at birth ranks amongst the lowest in the EU for both men and women. Amenable and preventable mortality remain higher than the EU average. Hungary also has the one of the highest mortality rates in the EU relating to non-communicable diseases among the working age population. ( ) This leads to a reduction of the available workforce. While disease prevention and healthy lifestyles have been promoted in recent years, current investments in these areas appear insufficient to improve health outcomes in the long run. Wide inequalities in access to healthcare also contribute to the poor health outcomes. The shortage of labour in the health sector continues to hamper accessibility. A comprehensive residence support programme was introduced in 2011 and announced again in 2016 to reduce shortages of medical staff. In addition, wages of health professionals have increased substantially since 2012. Nevertheless a comprehensive human resource strategy, focusing on primary care staff and taking into account regional disparities, is not yet in place to ensure an adequate workforce (European Commission and Economic Policy Committee, 2016). Out-of-pocket payments remain high. The share of out-of-pocket payments, which include the estimated amount of informal payment as well, has decreased but remains high by EU standard (26.5 % vs. 17.6 %). The lack of a clear consistent legal framework creates uncertainty and leaves room for legalising post-treatment acceptance of gratitude payments. 3.4. Investment Investment trends The private investment share in GDP has fallen since the crisis. While total investment stood at around a quarter of GDP before the crisis, it dropped below 20% thereafter. This drop has been driven by a contraction in private business investment, which dropped below the EU average in 2015. This continuous decline was due to investment contractions in both the corporate and the household sector (Graph 3.4.1). Business investment remains 10% below the pre-crisis level in real terms and is forecast to keep contracting. However, household investment is set for a progressive recovery after a decade of weakness. Government investment grew dynamically in recent years, reflecting an increasing level of EU fund absorption. It is expected to keep growing in the years ahead, after a temporary pullback in EU-funded investment in 2016 (Graph 3.4.1). Graph 3.4.1:Private and public investment in HU and the EU Source: European Commission, staff calculations based on the 2017 winter forecast

The sizeable decline in private investment reflected a drop in construction activity as house prices dropped. The peak-to-trough decline in construction investment was 36 % (2005-2012). It was especially marked in investment in dwellings, which contracted by 63 % between its peak in 2004 and its ebb in 2013. Household investment started to recover thereafter, and is expected to receive a boost from recovering house prices (Box 3.2.1). Productive investment in equipment did not contract as much and outgrew the pre-crisis peak already in 2014. Yet, it is estimated to have fallen considerably in 2016, as EU disbursements declined. Total investment remains below its pre-crisis levels in terms of both GDP and absolute volume (Graph 3.4.2). Graph 3.4.2:Investment volumes, index 2008=100 Source: Eurostat Equipment and machinery investment is important for making the economy more productive and competitive. Hungary’s high dependency on EU funds creates risks of postponing business investment, which could happen without external support, as companies wait for new funding opportunities or outcomes of their applications for EU funds. This leads to a dependency culture, which may be hard to break. Grants or co-financing support from EU funds involves much less risk for the recipient, but greater risks that the funds are not used on higher productivity- or growth-enhancing investment. From a macroeconomic perspective, the decline in private investment can be explained by deleveraging, banks’ limited willingness to lend and low domestic demand. Deleveraging pressures have started to ease but continue to constrain firms’ capacity to invest. The debt of non-financial corporations decreased from 79.3 % of GDP in 2009 to 62.3 % in 2015. Yet, it remains relatively high and limits the appetite of those firms to borrow, as they seek improvements in their balance sheets. In addition, the crisis was followed by several years of subdued domestic demand and tight financing conditions, which limited investment. More recently, domestic demand has been recovering and the lending capacity of banks has increased substantially. However, the willingness of banks to lend remains limited (section 3.2). Net foreign direct investment (FDI) flows decreased in 2015 but greenfield FDI inflows remained stable. Net FDI flows amounted to 1.6 % of GDP in 2015, down from 2.7 % in the preceding year. The net flows amounted to 2.3 % of GDP in the first three quarters of 2016. The stock of net FDI was at 35 % of GDP in 2015, which is about 6 pps. below the weighted average of the regional peers (Czech Republic, Slovakia, Poland). Greenfield FDI inflows remained stable in 2015 at 2.2 % of GDP (Graph 3.4.3). FDI can be an important source of technology transfer and productivity growth. It is also a source of non-debt financing of the external position and thus enhances the country’ shock absorption capacity. Graph 3.4.3:Greenfield FDI inflows into Hungary Source: Financial Times FDI Markets database, WEO database Oct2016, European Commission



Low investment has a dampening impact on Hungary’s potential growth (Graph 1.10). The low rate of potential growth was discussed in Section 1. It mainly reflects low total factor productivity growth, which in turn is linked to the low level of innovation in the economy. Without sustained growth in market-driven private sector investment, the contribution of capital accumulation to potential growth and productivity growth will remain moderate. Private investment is particularly important as EU-funded investment gradually subsides. Low investment limits productivity gains, which may make Hungary less competitive in the medium term. The cost competitiveness of the Hungarian economy has improved in the recent years due to the depreciation of the real effective exchange rate. This led to a partial reversal of previous market share losses, as the automobile industry and an export-oriented service sector expanded rapidly. However, recent and forecasted wage growth is significantly above productivity growth. This is expected to result in deteriorating cost competitiveness in the medium term, unless productivity increases significantly. In addition, there has been little improvement in Hungary’s non-cost competitiveness (more information in Box 3.4.1 and section 3.4.2) The minimum wage reform is planned to increase labour productivity but its outcome is uncertain. The reform was discussed in box 1.1 and section 3.3. The increase in minimum wage risks eliminating some low-productivity jobs and shifting labour to more productive jobs. In a closed economy, if labour becomes more costly, capital can substitute part of the labour as production input. However, in an open economy, the situation may be different. If labour costs increase or there are labour shortages, capital can move to other countries where labour is cheaper. This can be illustrated by the recent decision by a major multinational company to move their low-skilled production factory from Hungary to Ukraine. In real world, a mix of the above may happen. Nevertheless, traditional structural measures to enhance productivity, such as upskilling the labour force and promoting entrepreneurship, may achieve more predictable results. (Continued on the next page) Box (continued) Business environment Factors adversely affecting the business environment are linked to weaknesses in institutional performance and governance. The effectiveness of Hungary’s public administration appears to be relatively low by international standards (see section 3.6). The total administrative burden for businesses is estimated to be significantly above the EU average (OECD, 2015a). An unpredictable regulatory environment with frequent changes increases uncertainty and high compliance costs that weigh on investment. Some aspects of the competition framework, such as exception clauses in the application of competition law, also increase regulatory uncertainty. In addition, inefficiencies in public procurement generate corruption risks to the detriment of the business climate. Business dynamics are constrained by institutional and regulatory obstacles. Hungary displays a relatively high share of fast-growing companies. At the same time, the level of entry remains moderate as measured by the birth and survival rates of new firms (Eurostat, 2016). Overall, Hungary’s level of entrepreneurship ranks below the EU average (European Commission, 2017a). Firm entry and exit are hampered by the high costs of resolving insolvency (European Commission ibid; World Bank, 2016). The availability of alternative financial sources to bank lending such as venture and seed capital is about on par with the EU average, however a higher volume of venture capital would help more innovative firms to enter into the market and grow. Regulatory barriers introduced in recent years have made market entry more difficult in service sectors (see section 3.5). In the energy sector, below-the-cost regulated end-user prices coupled with the burden of sector-specific taxes significantly reduce the return on investment. The lack of a guiding framework for companies wishing to transfer their registered offices across borders is also a constraining factor. International rankings continue to flag challenges in the business environment and competitiveness. The World Economic Forum’s global competitiveness index ranks Hungary 69th out of 138 countries, a deterioration in the country’s relative position over the past ten years. Hungary appears to perform particularly weakly on institutional soundness. The World Bank’s 2017 Doing Business Report, which sheds light on how easy it is for entrepreneurs to open and run businesses, places Hungary 21st among all EU Member States (World Bank, 2016). The 2016 IMD world competitiveness scoreboard ranks Hungary 46th among the 61 economies. While Hungary’s ranking has stabilised in the last 5 years, indicators related to government efficiency have been on a declining trend. 3.5. Sectoral policies Research and Innovation Total spending on R&D increased in recent years, but public R&D intensity is falling. Although R&D spending in the business sector is still below the EU average, it has doubled as a percentage of GDP over the past ten years (Graph 3.5.1). However, business innovation is highly concentrated in a handful of large foreign-owned companies. At the same time, public R&D has been decreasing, leaving Hungary in the bottom group of EU Member States on this account. This weakens the science base which provides the knowledge and human resources for business development. The low quality of the public research and innovation system contributes to insufficient cooperation between higher education institutions, public research organisations and businesses. Graph 3.5.1:The evolution of R&D intensity by sectors Source: Eurostat Overall, innovation is not sufficiently embedded in the Hungarian economy. Hungary has been a major beneficiary of foreign direct investments over the past 25 years. This brought in high-technology production, which represents a significant proportion of manufacturing. However, domestically-owned firms have not been able to benefit from technological spill-overs from foreign owned enterprises, and their productivity has remained weaker. The limited knowledge transfer can be partly linked to the orientation of foreign companies towards their global production networks, while relying on low labour costs locally. The very low innovation propensity of small- and medium-size enterprises (SMEs) in terms of adopting new technologies and processes also reduces the scope for technological spill-overs. Similarly, only a small fraction of Hungarian SMEs are involved in in-house innovation activities (Graph 3.5.2). Human resource constraints, including weak entrepreneurship, play a major role in hampering innovation. The lack of highly-skilled professionals is a major obstacle that puts at risk investments in knowledge-intensive activities. ( ) Based on the European Innovation Scoreboard, which reflects the above factors, Hungary ranks 21st of the 28 EU countries in innovation performance (European Commission, 2016d). Graph 3.5.2:Performance of Hungarian SMEs in selected innovation indicators – measured in standard deviations (EU average=0) Source: European Commission The government's economic strategy puts emphasis on promoting innovation, but weaknesses in policy coordination tend to limit results.( )The National Research and Development and Innovation Strategy (2013-2020) laid down policies explicitly targeting innovation in SMEs. However, there are mismatches between the planned measures and the actual situation of SMEs. Hungarian R&D, especially in the small busines sector, is heavily dependent on EU Structural Funds and other external sources. Yet, R&D grants do not appear to have the desired broad effect in stimulating innovation across the economy. Considerable funds are available to support business R&D during the 2014-2020 programming period. Yet, appropriate evaluation and monitoring mechanisms to safeguard the effective utilisation of these resources are missing. There is only limited policy coordination to ensure the complementarity and continuity of different programmes. Digital economy

While Hungary scores close to the EU average in broadband connectivity, significant gaps exist in mobile services. Fixed broadband networks now are accessible for 95 % of homes, close to the EU average. At the same time, in 2015, already 75 % of households had a fixed broadband subscription, compared with the EU average of 74 %. However, Hungary performs relatively poorly on mobile services. Take-up rates are by far the lowest within the EU for mobile subscriptions and particularly for mobile internet subscriptions (42.7 % vs. the EU average of 60 %). This does not stem from infrastructure constraints as coverage is already extensive for basic mobile and 4G services. At the same time, prices for mobile phone users are considerably higher than in the rest of the EU (Van Dijk 2016; OECD 2016a). This can be linked to the existing regulatory and market structure. The high price level also reflects the effect of the tax burden imposed on the sector, including the sector-specific telecommunication tax (Deloitte, 2015). The use of information and communications technologies by businesses and public administration stands below the EU average. The proportion of firms relying on technologies such as electronic information sharing (16 %), cloud services (8 %) or social media (13 %) is among the lowest in the EU. Hungarian businesses also take limited advantage of e-commerce. Very few Hungarian SMEs sell online (12 % in 2016), and even fewer sell online to other EU Member States (4.5 %). The reluctance of consumers to engage in electronic transactions is a factor behind this (Eurostat 2017). The latest e-Government Benchmark Report reveals that Hungary underperforms in all key dimensions of digital public administration (Capgemini et al. 2016). Regulation in the service sector Although product market regulation is not particularly strict in general, access to several service sectors continues to be constrained. Over the past years, several segments of the service sector saw the introduction of new regulatory barriers in previously open markets. The affected areas include retail outlets, tobacco retail, pharmacies, waste management public service, textbook publishing and distribution or mobile payment systems. During 2016, no substantial steps were taken to ease the recently erected entry barriers in service sectors. On the contrary, the government adopted new, tighter requirements for passenger transport services operated by independent dispatching centres. Increasing restrictions to entry in certain service sectors hinder the efficient allocation of resources and innovation-enhancing business dynamics, while also generating uncertainty for investors. Regulation in the retail sector is restrictive and the transparency of rules is relatively low. Hungary is the only Member State where the level of restrictiveness in retail has more than doubled over the past decade and is currently above EU average (OECD, 2016a). However, the OECD indicator does not capture all the restrictions that were recently introduced. Unclear application of the rules on setting up stores above a certain size ( ) and the ban on loss-making are significant barriers to market entry and to the expansion. Hungary is one of the few countries in the EU where mark-ups in the retail sector have not declined since 2000 (Thum-Thysen and Canton, 2015). Regulatory restrictions weigh on the sector's productivity and also reduce incentives to invest (European Commission, 2015d). Regulation on professional services remains restrictive. Based on an indicator developed by the European Commission (2016f;g), the degree of regulatory restrictiveness in Hungary exceeds the EU average for several professions examined, especially for tourist guides, civil engineers, estate agents and patent agents. In addition, for accounting and legal services business the churn rate ( ) was found to be comparatively low. This suggests a relatively weak market dynamism and competition in these services. In November 2016, the authorities submitted an action plan to review the existing regulatory provisions for professions. It indicated intentions to reform regulation for professions in the tourism and construction sectors. Energy and environment Hungary is heavily dependent on energy imports, particularly crude oil and natural gas. Some 62 % of the country's energy needs are covered by imports. Electricity and gas interconnector projects between Hungary and its neighbours have a beneficial impact on energy security and the energy import bill. However, without a commonly agreed solution for the definition of appropriate bidding zones in Central and Eastern Europe, limitations to cross-border electricity trade are still frequent, with negative consequences for the internal electricity market. On the retail side, regulated electricity and gas prices for households are not cost reflective, resulting in financial losses to the service providers. Below-cost regulated prices have prompted energy retailers to return their universal supply licences for household costumers, and the service has been increasingly taken over by state-owned companies. One state-owned company (Főgáz Ltd.) is now practically the sole provider of natural gas to households. This results in a lack of consumer choice and competition. Below-cost prices do not subsidise only the vulnerable households, but also all the wealthier customers. The accumulating potential financial losses in the balance sheet of state-owned energy retailers are not sustainable in the long run and may eventually burden the state budget (OECD, 2016a). Hungary is on the right track to meet its greenhouse emission targets, but the economy is still characterised by high energy intensity. In 2015, the level of Hungary's greenhouse emissions was 35 % less than in 1990 and expected to decline further. Energy consumption also decreased over the past decade linked to the economic downturn during the crisis. The energy intensity of the Hungarian economy still significantly exceeds the EU average. ( ) The current volume of final energy consumption remains above the indicative 2020 target (by around 13 %). There is considerable energy saving potential in modernising district heating systems and renovating the residential building stock. However, there is a risk that this saving potential will not be properly exploited as EU funds initially allocated to support residential housing renovation are intended to be re-channelled to finance the modernisation of public buildings. The waste management sector has experienced increased central regulation involving measures, which pose risks to its long term viability. The scope for competitive arrangements has been reduced by restricting the presence of privately owned operators. As of 2013, waste collection fees for households were capped and reduced generating financial losses for several municipal service providers. In 2016, a new nationwide system was introduced for waste collection. Under the new regime, uniformly set fees are collected by a national holding company, which then redistributes the revenues between local operators. There is a danger that this highly centralised setup will not be able to ensure the right incentives and prices to cover the costs of waste management in locally differentiated markets. Hungary's circular economy remains underdeveloped. The existing economic instruments do not effectively support the achievement of the EU’s 2020 and 2030 waste management targets.( ) The tax system does not facilitate eco-friendly solutions. The landfill tax has remained at a low level since 2013, and no incineration tax exists, which could help prevent waste from being shifted to incinerators. The selective door-to-door collection of municipal waste and the extended producer responsibility schemes are not well developed (European Commission, 2016h). The national strategic framework for waste management does not cover all relevant parts of the circular economy and lacks regional plans. 3.6. Public administration Regulatory quality and administrative reform Internationally collated scoreboard indicators point to a low and deteriorating quality of institutions. The Worldwide Governance Indicators data show that Hungary’s performance has declined in all the six broad dimensions related to the quality of policy making over the past ten years (Graph 3.6.1). Since 2010, the deterioration is particularly noteworthy in accountability, regulatory quality and rule of law. The slide in executive capacity and executive accountability is also shown by the Bertelsmann Institute’s governance indicators (Bertelsmann, 2016). Institutional quality tends to be closely related to the level of economic development. However, based on these accounts, Hungary is not only amongst the group of lowest performing EU Member States, but also lags behind most regional peers. ( ) The weak institutional framework could be a drag on the economy's growth potential. Policy uncertainty is one of the most important barriers to doing business in Hungary. According to the World Economic Forum, Hungary ranks 136 of 138 countries in the transparency of policy making (WEF, 2016). Empirical research on the Hungarian legislative process reveals several critical aspects of regulatory quality (CRCB, 2015; 2016; 2017). It finds that, despite a legal requirement, regulatory impact assessments are not available for a significant number of laws. Publicly accessible impact assessments typically contain only a short assessment sheet with little quantitative information on the effects of proposed policies. The research also highlights a deficit in appropriate stakeholder engagement. For government initiated proposals, consultations tend to be limited to very short time periods, around 4.5 days in the last three years. Transition periods allowing the affected parties to prepare for policy implementation are often inadequate. In 2014-2016, on average only 45 days elapsed between the submission of a draft bill and the publication of the adopted new law, significantly shorter (by around 20 days) than in the previous decade. To address these problems, the government has launched an ambitious reform programme to improve regulatory quality, but results are still to be seen. In 2015, the government adopted a new public administration and public services development strategy. This aims to increase administrative effectiveness through organisational integration, reducing administrative costs, improving human resource management and digitising public administration. ( ) The Commission has set a deadline (31 December 2016) to prepare a detailed action plan in relation to the implementation of the strategy, which will be assessed in early 2017. Graph 3.6.1:Hungary: Quality of institutional performance - 2005-2015 Source: The Worldwide Governance Indicators, 2016 Update A range of justice system reforms have also been recently adopted or initiated. These include reforms of the civil, administrative and criminal procedural code, new rules for electronic communication between public administration and courts and a new regime for attorneys at law. At the same time, plans to set up a new administrative court system raised important concerns on the part of the judiciary (OBT, 2016) and have been postponed. The impact of these reforms on the effectiveness of the Hungarian justice system requires close monitoring. Challenges remain, as businesses' perception of judicial independence has worsened over the last three years (European Commission, 2017b). The performance of the legal system is also adversely affected by the excessive length of civil procedures and the lack of effective domestic legal remedies as established by a pilot-judgment of the European Court of Human Rights. An adequate response by the government to this judgment is still awaited. ( ) Public procurement

Public procurement consistently suffers from limited competition and transparency. Empirical research on Hungarian public procurement showed that the intensity of competition declined in 2009-2015, while in that period the share of contracts awarded to a single bidder remained high, at around 30 % on average (Tóth and Hajdú, 2016;Tóth, 2016). The study documented that the transparency of procedures had decreased in recent years andthere was also a detectable tendency towards price distortion. This analysis also found that procurements involving EU funds had worse performance than domestically funded ones. Comparable data across countries on tenders above the EU threshold value reveal that single-bid contract awards and negotiated procedures without prior publication of the tender have been more extensively used in Hungary than in most other Member States (European Commission TED database). Limited competition and transparency in public procurement generates corruption risks and social losses in terms of value for money. Data on public procurement procedures for 2016 following the adoption of the new procurement act show some improvements, but challenges still remain. In 2016, the proportion of tenders without prior publication above the EU threshold decreased to 9 % from 13 % in 2015. Despite the decline, the proportion of such procedures still remained above the European Economic Area average (5%). At the same time, there was no significant improvement in the share of contracts above the threshold that attracted only a single bidder. In 2016, 36% of tenders (excluding frameworks) belonged to this category, while 37% in 2015. This value is the 6th highest in the European Economic Area compared to an average of 17% (European Commission, 2017c). To assure the effective and efficient use of EU Structural and Investment Funds in 2014-2020, Hungary drew up an action plan where it committed itself to undertake several measures to increase legality, competition and transparency in public procurement. In that context, a new public procurement act was adopted in November 2015 to ensure compliance with EU directives in the area. (