REPORT FROM THE COMMISSION TO THE COUNCIL Commission report to the Council pursuant to Article -11(2) of Regulation (EC) No 1466/97 on the enhanced surveillance mission in Hungary, of 18-19 September 2018
Date: 2018-11-21
Institutions: Directorate-General for Economic and Financial Affairs, European Commission
Subjects: Hungary, budget deficit, economic convergence, economic reform, financial control, gross domestic product, multilateral surveillance, public debt, public finance, stability programme

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   EUROPEAN COMMISSION  Brussels, 21.11.2018  COM(2018) 804 final  REPORT FROM THE COMMISSION TO THE COUNCIL Commission report to the Council pursuant to Article -11(2) of Regulation (EC) No 1466/97 on the enhanced surveillance mission in Hungary, of 18-19 September 2018  
 
 
This  report  on  an  enhanced  surveillance  mission  to  Hungary  is  transmitted  to  the  Council 
pursuant to Article -11(4) of Regulation (EC) No 1466/971. As foreseen by Article -11(5) of 
Regulation  (EC)  No  1466/97,  the  provisional  findings  of  that  mission  have  been  previously 
transmitted to Hungarian authorities for comments. 

Hungary – Significant Deviation Procedure 
Enhanced surveillance mission, 18-19 September 2018 

Report 

1. Introduction 

A Significant Deviation Procedure (SDP) was launched for Hungary in spring 2018 as a 
consequence of an observed significant deviation from the requirement of the preventive 
arm of the Stability and Growth Pact (SGP) in  2017. On 23 May 2018, the Commission 
issued  a  warning  to  Hungary.  The  Council  Recommendation  adopted  on  22  June  2018 
confirmed  the  Commission's  assessment  and  called  on  the  authorities  to  take  the  necessary 
action in order to restore the appropriate adjustment path towards the medium-term budgetary 
objective  (MTO).  In  particular,  the  Council  recommended  taking  the  necessary  measures  to 
ensure that the nominal growth rate of net primary government expenditure does not exceed 
2.8%  in  2018,  corresponding  to  an  annual  structural  adjustment  of  1%  of  GDP.  The  2018 
fiscal  Country  Specific  Recommendation  directly  referred  to  that  SDP  recommendation. 
Hungary has reported to the Council on actions taken as requested by 15 October 2018. The 
assessment of action taken by Hungary has been adopted by the Commission on 21 November 
2018. This report presents Commission's findings from the enhanced surveillance mission to 
Hungary that took place between 18 and 19 September 2018.  

For 2018, the Commission 2018 spring forecast projected the headline deficit to increase 
to  2.4%  of  GDP  from  2%  in  2017,  and  the  structural  balance  was  estimated  to 
deteriorate further. The fall of temporary revenues contributes to the increased deficit, so do 
additional  tax  cuts.  At  the  same  time,  the  growth  of  government  expenditure,  excluding 
spending  from  EU  funds,  was  expected  to  slow  down,  compared  to  2017.  However,  net 
primary expenditure, adjusted for one-offs and discretionary measures, was still estimated to 
increase above the country's medium-term rate of potential GDP growth, well exceeding the 
reference rate reflecting the requirement of the preventive arm. 

The  enhanced  surveillance  mission  by  the  Commission  took  place  on  18-19  September 
2018.  The  aim  of  the  mission  was  to  learn  about  the  views  of  the  authorities  on  fiscal 
developments  and  the  actions  planned,  and  to  encourage  compliance  with  the  SGP.  The 
Commission  staff  met  with  (i)  Minister  Mr.  Mihály  Varga  and  State  Secretaries  Mr.  Péter 
Banai and Mr. Norbert Izer, Ministry of Finance; (ii) Mr. Árpád Kovács, the president of the 
Hungarian Fiscal  Council; and (iii) Mr.  Barnabás Virág, Executive Director of the National 

1 Council Regulation (EC) No 1466/97 of 7 July 1997 on the strengthening of the surveillance of budgetary positions and the surveillance 
and coordination of economic policies, OJ L 209, 2.8.1997, p. 1 

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Bank of Hungary. The mission also discussed the context and implications of the SDP with 
Members  of  the  Hungarian  Parliament  from  the  Committees  of  Budgetary  and  European 
Affairs, and with the representatives of social partners and think tanks. This report is based on 
information obtained until and during the mission. 

2. Findings of the mission 

The  Hungarian  authorities  do  not  plan  major  steps  this  year  in  response  to  the  SDP 
Recommendation,  while  they  seem  committed  to  tighten  the  budgetary  stance  starting 
from  2019  onwards.  In  2018,  the  authorities  intend  to  stick  to  their  initial  general 
government deficit target. At the same time, the 2019 budget, which was already adopted in 
July 2018, aims to bring down the headline deficit by 0.6% of GDP next year. However, the 
SDP Recommendation does not cover 2019.  

Hungary  made  substantial  efforts  to  consolidate  its  public  finances  after  the  crisis  but 
this  process  recently  lost  momentum,  while  public  debt  remains  high,  above  70%  of 
GDP.  Hungary  acceded  to  the  Union  with  a  high  deficit  and  was  subject  of  an  Excessive 
Deficit Procedure between 2004 and 2013. Since then, the government deficit has been safely 
kept below the 3% of GDP threshold. The mission commended this achievement, but pointed 
out that fiscal consolidation had recently halted. According to the Commission's assessment, 
the  fiscal  stance  became  highly  pro-cyclical  after  2016.  This  notably  entails  important  risks 
for the future, when adverse shocks hit again. While the growth of the Hungarian economy is 
amongst  the  fastest  in  the  EU  in  2018  (i.e.  4.7%  in  the  first  half  of  the  year)  and  there  are 
already signs of overheating, the nominal deficit planned at 2.4% of GDP for this year is the 
third highest in the EU (and well above the EU average of 0.6% of GDP). Moreover, the level 
of public debt at around 73% of GDP still remains high. Some Members of Parliament as well 
as  the  economic  experts  who  met  with  the  Commission  staff  during  the  mission  concurred 
that there was a need to revise pro-cyclical fiscal policy in Hungary. 

While the Hungarian authorities admitted some pro-cyclicality in fiscal policy, they had 
a different evaluation of the gravity of the problem regarding the assessment of the 2017 
budget outcome already. The Commission estimates that the output gap exceeded +1.5% of 
GDP  in  2017.  By  contrast,  according  to  the  calculations  of  the  Ministry  of  Finance,  the 
negative output gap was still closing at that stage. Therefore the authorities estimate a notably 
better  structural  fiscal  position  than  the  Commission.  In  their  assessment,  the  structural 
balance remained close to the MTO in 2017 (at -1.7% of GDP compared to the MTO of-1.5% 
of GDP) and thus  the opening of the SDP  was  not  warranted.  In response, the Commission 
staff stressed that the assessment of the compliance with the provisions of the SGP must be 
based on the methodology commonly agreed by all Member States. The mission also pointed 
out  that,  recognising  the  uncertainties  surrounding  the  estimation  of  the  cyclical  position, 
increased  emphasis  had  been  placed  in  parallel  on  the  expenditure  benchmark  in  the 
Commission's  assessments.  However,  on  that  basis  as  well  it  could  hardly  be  disputed  that 
significant deviation was observed in 2017. Even without counting the impact of significant 

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tax cuts, primary expenditure (netting out EU funds and one-offs) grew well above Hungary's 
potential GDP growth in 2017 on any account. 

Regarding  the  high  observed  expenditure  growth  in  2017,  the  authorities  noted  that  it 
masked  a  significantly  improved  underlying  budgetary  position  (i.e.  the  "genuine" 
structural balance). In 2017, the government decided to partly spend savings and higher-than-
expected  revenues  on  non-recurring  discretionary  items  (mostly  transfers  to  the  private  and 
non-profit sectors) at the end of the year. Despite this, the fiscal deficit turned out to be lower 
than the nominal target in 2017. The Commission suggested that, were such a constellation to 
occur again towards the end of 2018, the revenue gains should be used to reduce the structural 
deficit  in  line  with  the  SDP  Recommendation  instead  of  incurring  extra  discretionary 
spending. 

The Hungarian authorities indicated that they did not see it reasonable to implement the 
substantial fiscal adjustment recommended by the Council for the second half of 2018. 
In  their  view,  the  budgetary  outcome  in  2018  was  already  largely  determined  by  previous 
decisions  and  the  proposed  adjustment  in  the  rest  of  the  year  would  harm  the  economy. 
Nonetheless,  they  mentioned  certain  actions,  which  could  improve  the  budgetary  position 
already in 2018 or at least pose some positive risks (e.g., the mandatory e-invoice system for 
inter-company transactions as of 1st July 2018 aiming at enhancing tax-collection efficiency), 
or  facilitate  spending  restraint  planned  for  2019  (e.g.  starting  the  rationalisation  of  staffing 
levels  in  public  administration).  The  authorities  stated  that  only  a  temporary  departure  was 
expected from the MTO in 2018, which was to be reversed in 2019. 

The Commission delegation noted that the adoption of the 2019 budget was a step in the 
right direction. At the same time, the mission warned that the government plans for 2019 still 
involved  a  risk  of  significant  deviation  from  the  required  adjustment  taking  2018  and  2019 
together as shown by the Commission's assessment of the 2018 Convergence Programme. In 
other  words,  the  implementation  of  the  2019  budget  as  foreseen  is  expected  to  result  in  an 
improved  structural  balance,  but  does  not  seem  sufficient  to  reverse  the  effects  of  the 
preceding  pro-cyclical  fiscal  policy  on  the  budgetary  position,  especially  if  there  was  no 
notable improvement in 2018. It also noted that the budgetary plans for next year seem to rely 
strongly  on  an  optimistic  macroeconomic  scenario  assuming  a  sustained  GDP  growth  at 
around  4%.  In  this  respect,  the  authorities  highlighted  that  the  budgeted  level  of  stability 
reserves was increased to provide a buffer in case of a less favourable situation. 

There is a risk that the medium-term impact of recent tax cuts on fiscal revenues could 
be  higher  than  the  Hungarian  authorities  assume.  Hungary  has  recently  implemented  a 
series of sizeable tax cuts.  It included in particular successive reductions of employer social 
security  contributions  in  2017  and  2018,  which are  also  planned  to  continue  next  year.  The 
budgetary effect of the reductions in social contributions to date remains dampened, given the 
tight labour market and fast rising wages. The mission cautioned that the impact of these cuts 
may  become  larger  when  these  conditions  wither  with  the  economic  cycle.  The  authorities 
agreed  that  such  risks  existed  but  argued  that  the  impact  of  dynamic  wage  growth  on  the 

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revenue-to-GDP ratio seen so far could be regarded as largely permanent. The wage share in 
the economy is on a recovery path reversing the decline seen after the crisis. This might also 
have been helped by the recent substantial minimum wage increases, which also provided a 
"whitening effect" by curbing undeclared incomes. 

The  dynamics  of  public  investment  are  highly  pro-cyclical.  Hungary  is  accelerating  the 
execution  of  government  investments,  including  both  nationally  and  EU  funded  projects. 
Total  public  investment  expenditure  is  set  to  rise  rapidly  during  2018  and  2019,  reaching  a 
historic  high  of  around  7%  of  GDP  in  2019.  The  Commission  noted  that  this  heavily 
frontloaded schedule did not seem to be consistent with the cyclical position of the economy. 
Given the current tight capacity constraints in construction, this can result in a crowding-out 
effect adversely affecting private sector investments, while also pushing up the costs of public 
projects. Moreover, if a sufficient fiscal space is not secured during the economic expansion, 
the  government  would  be  forced  into  a  rapid  unwinding  of  investments  when  the  next 
recession occurs. This would accentuate output fluctuations at the wrong moment and in the 
wrong  direction.  In  that  regard,  think  tanks  and  social  partners  expressed  their  concern  that 
the  strong  acceleration  of  public  investments  could  negatively  affect  the  quality  of  public 
spending. 

The  Hungarian  Fiscal  Council warned  that  the  budgetary  plans  for  2017-2019  did not 
comply  with  the  national  domestic  rule  pertaining  to  the  structural  balance.  The 
structural  balance  rule  of  the  Hungarian  Stability  Law  prescribes  that  the  budget  bill 
submitted by the government should be in conformity with the MTO each year. In its opinions 
issued on the draft budgets, the Fiscal Council compares the MTO with the structural balance 
as estimated by the government prior to the budget execution. As the budgetary plans for the 
years  2017-2019  contained  an  estimated  structural  deficit  exceeding  the  MTO,  the  Fiscal 
Council  consequently  stated  that  those  plans  were  in  breach  of  the  corresponding  domestic 
rule.2 The Fiscal Council did not expect an improvement in 2018 in that regard. In its report 
on the 2018 fiscal developments, which was published during the mission, the Fiscal Council 
was  of  the  opinion  that  the  budgetary  target  for  the  2018  general  government  deficit  set  in 
ESA  terms  can  be  achieved.  At  the  same  time,  it  called  the  authorities  to  resort  to  strict 
budgetary control in the rest of the year, especially concerning spending by central budgetary 
institutions  and  chapters.    The  Fiscal  Council  also  noted  that  there  was  a  high  risk  that  the 
cash-flow  deficit  will  turn  out  to  be  considerably  higher  than  planned.  This  was  due  to 
substantial advance payments towards EU funded projects coupled with a much lower-than-
expected rules-based disbursement of transfers by the EU. 

The  National  Bank  of  Hungary  (MNB)  agreed  that  fiscal  policy  became  pro-cyclical 
after  2016,  albeit  to  a  lesser  extent  than  assessed  by  the  Commission,  and  projected  a 
counter-cyclical  fiscal  stance  in  2019  and  2020.  The  MNB  emphasised  the  importance  of 

2 The MTO of Hungary is a structural deficit of 1.5% of GDP. The three successive budget bills adopted between 2016 and 2018 were based 
on a planned structural deficit of 2.1% of GDP for 2017, 2.4% for 2018 and 1.7% for 2019 as calculated by the  government. Therefore in 
each budgetary round there was a planned deviation from the MTO. 

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the  structure  of  the  fiscal  impulse.  In  its  assessment,  significant  temporary  effects  also 
contributed  to  fiscal  loosening  particularly  in  2018,  including  the  phasing-out  of  land  sales 
and  extraordinary  corporate  income  tax  receipts  under  the  Growth  Tax  Credit  scheme.  In 
addition,  the  MNB  stressed  the  uncertainties  regarding  the  assessment  of  the  output  gap. 
While  capacity  utilisation  and  labour  market  indicators  suggest  diminished  slack,  financial 
variables (including the positive current account balance and the low credit-to-GDP ratio) do 
not  point  to  overheating.  Regarding  the  macroeconomic  policy  mix,  the  MNB  argued  that 
while  fiscal  and  monetary  policy  has  been  loose  until  recently,  this  stance  will  gradually 
change,  and  that  macro-prudential  policy  has  remained  tight  in  order  to  contain  financial 
vulnerabilities. 

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