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# 52012SC0317

**COMMISSION STAFF WORKING DOCUMENT Assessment of the 2012 national reform programme and convergence programme for HUNGARY Accompanying the document Recommendation for a COUNCIL RECOMMENDATION on Hungary's 2012 national reform programme and delivering a Council opinion on Hungary's updated convergence programme , 2012-2015 /\* SWD/2012/0317 final \*/**

  

CONTENTS

Executive summary. 3

1........... Introduction. 4

2........... Economic developments and challenges. 5

2.1. Recent economic
developments and outlook. 5

2.2. Challenges. 6

3........... Assessment of policy agenda. 9

3.1. Fiscal policy
and taxation. 9

3.2. Financial
sector 17

3.3. Labour market,
education and social policy. 18

3.4. Structural
measures promoting growth and competitiveness. 22

3.5. Modernisation
of public administration. 24

4........... Overview table. 27

5........... Annex. 31

              Executive summary

In 2012, the economic activity of Hungary is expected to contract by
0.3%, before regaining some momentum in 2013. Unemployment is foreseen to
slightly decrease to 10.6% in 2012 and to fall further in 2013.

In the context of the overall consolidation process and following a
Council decision in January 2012 that Hungary had not taken effective action, the
government undertook efforts to secure the budgetary targets for 2012 and also
in 2013 when substantial one-off revenues are phased out. There have been first
steps to broaden the remit of the Fiscal Council but it still does not include
crucial tasks and multiannual fiscal planning remains indicative. Further, the Hungarian
government has pursued an extensive structural reform agenda including key
elements targeting the labour market as well as steps to reform the business
environment. In several areas, policy responses remained rather incomplete.

Hungary continues to face serious challenges in
the short to medium term. The attainment of the deficit target of 2.5 % of
GDP in 2012 and 2.2 % of GDP in 2013 will have to be ensured in a
sustainable way. The already adopted cardinal law on economic stability does
not include a binding medium-term budgetary framework. Further, the recent tax
changes have negatively impacted low earners and have therefore not contributed
to enhancing employment. The public employment service has been reorganised
resulting in an overall downsizing, pointing in the opposite direction of what
was recommended in 2011. A further challenge relates to the transparency and quality
of public administration, where Hungary ranks low on many indicators. The
equity and effectiveness of the school system is also of concern, especially
with regard to recent legislative changes that risk increasing the number of
early school leavers and segregation in the Hungarian school system.

              1.       Introduction

In June 2011 the Commission proposed five country-specific
recommendations (CSRs) for economic and structural reform policies for Hungary. In July 2011 the Council of the European Union adopted these recommendations which
concerned public finances, including fiscal governance, the labour market,
and the business environment (lowering administrative burden and improving
access to non-bank funding). In November 2011 the Commission published its
Annual Growth Survey for 2012 (AGS 2012) in which it set out its proposals for
building the necessary common understanding about the priorities for action at
national and EU level in 2012 and encouraged Member States to implement these
priorities in the 2012 European semester.

Against this background, Hungary presented updates of its National
Reform Programme (NRP) and Convergence Programme (CP) in April 2012. These
programmes give details on progress made since July 2011 and plans going
forward. This Staff Working Document assesses the state of implementation of
the 2011 CSRs and it identifies Hungary's current policy challenges in light of
the AGS 2012 and the country’s latest policy plans.

Overall assessment

Hungary's progress towards meeting the 2011 Council
recommendations has been mixed. The Council decided in January 2012 that Hungary had not taken effective action in response to its recommendations under the
Excessive Deficit Procedure and in March it issued new recommendations, following
which the Hungarian authorities decided on further consolidation measures in
April. The Fiscal Council's remit has been broadened but it still does not
include crucial tasks (e.g. regular publication of macro-fiscal baselines), and
multiannual fiscal planning remains indicative. The government has an extensive
structural reform agenda with several elements targeting the labour market, and
notable advances have been made. Nevertheless, policy responses in areas such
as taxation, encouraging women's participation in the labour market or active
labour market policies have been piecemeal, or otherwise problematic. Steps
have also been taken to reform the business environment, but progress has not
been uniform.

The challenges identified in July 2011 and re-iterated in the AGS
2012 therefore remain valid. Fiscal consolidation is a pressing challenge for Hungary, but wider reforms also remain necessary to promote the conditions for sustainable,
investment-led growth. Hungary faces ongoing challenges to raise the
participation rate and the employment rate, to improve active labour market
policies and social inclusion, particularly in education, to broaden access to
high quality, affordable childcare, to reduce the administrative burden and
improve the business environment, as well as improving the transparency and
quality of public administration.

Hungary's 2012 NRP
and convergence programme contain significant measures whose specification
(where still necessary) and implementation could facilitate the progress
towards addressing key challenges. Nevertheless, steps could be taken to ensure
that policymaking supports these goals more coherently
and efficiently.

              2.       Economic developments and
challenges

              2.1. Recent economic
developments and outlook

Recent economic developments

The Hungarian economy started 2011 amidst a number of
indicators pointing towards accelerating real GDP growth to close to 3% supported
by a slow rebalancing in the economy. The developments over the course of the
year led to a significant revision of this picture given the deterioration of
the external environment which played out over several channels (a decline in
external demand, higher funding costs, hiking instalment payments on foreign
currency denominated loans), as well as squeezed domestic demand and policy
uncertainties. GDP growth in 2011 turned out to be at 1.7% as the main engine
of the economy was the export sector, which will continue to drive growth over
the forecast horizon.

Economic outlook

In the 2012 Spring Forecast, the Commission services project GDP to
contract by 0.3% in 2012, and to recover to a modest growth rate of 1% in 2013.
This does not incorporate the GDP flash estimate for the first quarter which showed
a much stronger-than-expected contraction of 1.3%. The ongoing deleveraging in
the enterprise and household sectors is expected to remain pronounced, with
credit supply constraints remaining significant and biting especially for
corporations. Against this background, the newly specified measures in Hungary's 2012 convergence programme will further depress domestic demand. In particular,
in 2013 the financial transaction tax is the new measure that is expected to
have the largest negative impact on the economy. It is anticipated to depress
gross fixed capital formation as it will primarily affect companies (depending
on the eventual legislative details it may put a further drag on bank lending),
but it is also projected to have a substantial negative impact on private
consumption expenditure. The enterprise sector will be further hit by the
redesigned insurance and energy levies, and some of the measures introduced in
the course of 2012, including the new telecommunications levy, will have an
additional negative impact as they will be in force throughout 2013.

Although Hungary's largest export markets are projected to be growing
at a lower rate than anticipated at the time of the autumn 2011 forecast, the
lower import projections mean that the contribution of net exports to growth
will remain significant. Hungary is also expected to gain market share as a
result of new automobile factories coming on line, starting in the second
quarter of 2012. The current account is estimated to increase further over the
forecast horizon. The new tax measures also imply that inflation is likely to
remain well above the central bank's target rate over the forecast horizon.[1] Unemployment is expected to
decline from this year, with Hungary's expanding public works scheme to provide
most of the employment growth in 2012-2013.

The authorities used the Commission's QUEST III model to estimate
the impact of several structural measures. Some of the assumptions they used
(e.g. a 50% reduction in administrative burden) appear to have skewed the
results. In any case, the macroeconomic projections presented in the NRP and
the convergence programme do not directly build on the output of their
modelling exercise. The Hungarian authorities share the Commission's view that
the economy will be driven by net exports over the forecast horizon, but the
government is more optimistic regarding domestic demand, particularly in 2013.
In 2012, the projected fall in government consumption expenditure appears on
the low side in volume terms given the consolidation measures. In nominal terms
the difference in the GDP forecasts is smaller since the authorities' inflation
forecast is surprisingly low given the new measures. Concerning 2013, the
forecast of private consumption expenditure growth is on the high side, driven
by more sanguine assumptions regarding employment growth in the private sector.
Gross fixed capital formation is also more positive in the authorities' 2013
forecast, since they assume that several of the measures such as the financial
transactions tax would impact technology rather than shorter term capital
investment.

Procedural and governance issues

Hungary
submitted both the NRP and the convergence programme on 23 April
2012. The documents are fairly substantial, broadly consistent and follow the
agreed guidelines. The two documents outline in an integrated manner the fiscal
consolidation efforts and key structural reforms as well as reforms
underpinning macro-economic convergence. The NRP in particular includes a
large number of measures that either have not yet been implemented or still are
in a conceptual phase and are not presented in greater detail. It also outlines
progress towards national targets for the year 2020, putting imminent
reform priorities in a broader context. Local authorities, Social Partners
as well as civil society were consulted on a number of programmes and
important measures included in the NRP, but there was no consultation on the
overall reform strategy. The legal status of the 2012
NRP is also difficult to interpret, since in contrast with 2011, the government
did not pass a regulation in order to adopt it.

                        2.2. Challenges

Concerns persist over Hungary's long-term potential growth. Reforms over
the past few years appear to have born fruit so far in expanding the labour
supply, which is a much needed step and it will be important to continue
advancing on this front. Eventually, labour reforms will also need to be
translated into gains in employment and competitiveness, where considerable
structural challenges persist. In addition, potential growth is likely to have
suffered from the fact that gross fixed capital formation has continued
declining, and the investment ratio is the lowest since 1997.

Specific labour market challenges include supporting demand for
low-skilled labour on the open market, given that the employment rate of this
group is 25.9% as against the EU average of 45.1%. In addition, raising the
employment rate among the Roma is a particularly important objective,
especially in certain regions: although official statistics do not exist, some[2] estimated their employment rate in the North Hungary region at 17%
as against 57% in the Central Hungary region in 2010. The submitted Social
Inclusion (Roma) Strategy and other mainstream policies are not aligned
properly which undermines the success of the strategy. In parallel with
the doubling of the funds allocated to public works, expenditure on other
active labour market policies is being scaled down. The
recent changes to labour taxation have increased the marginal tax rate for low
earners, while the complex system currently in place to ameliorate the impact
of the increased tax burden on this income group might have ambiguous effects
on their employment rate. The youth employment rate (around 18% against the EU
average of 34%) and the labour force participation of women with young children
(around 49% in 2011 vs. the EU average of 65.5%) are also very low, and while
some limited advances have been made in increasing childcare facility
capacities, these are outstripped by demand.

While there are some promising
developments in vocational training, where the business sector has been
involved in the redesign of courses, life-long learning continues to be
lagging. Investment in human resources in the natural sciences, mathematics,
engineering and related fields also remains particularly important for
improving growth potential. The current proportion of the labour force with
such skills is below the EU average. Special attention to the profile of
science and mathematics in general education would be helpful to prepare pupils
for tertiary studies in these areas, and improving the output of primary
education would seem necessary at least to counterbalance the reduced attention
to basic skills in vocational education. There are also concerns that the
changes afoot to the education system may deepen socio-economic inequalities
further. Neither the current and planned cuts to
education nor the underprivileging of R&D (where expenditure in Hungary remains significantly below the EU average) fits with the AGS recommendation of
smart consolidation.

The low level of economic confidence is
reflected in a range of indicators, from the World Bank 2012 Doing Business
indicator where Hungary was ranked 122nd globally in the category of investor
protection, to the latest Global Competitiveness indices cited in section 3 of
this paper. Shortcomings in the stability, predictability and transparency of
the institutional and policy framework clearly remain obstacles to be surmounted
in order to improve investment in Hungary (see also Box 1).

In the financial sector, credit supply
constraints remain significant, and biting in the case of enterprises. Many of
the parent companies of foreign-owned banks are under pressure to deleverage
given the broader economic and regulatory context, but policy developments have
aggravated the situation. In addition to the financial sector levy, the early
repayment of foreign currency denominated mortgages at discounted rates has
contributed to heavy losses in the banking sector and increased policy
uncertainty, although an agreement with the Banking Association in December has
somewhat ameliorated the situation. However, the planned introduction of the
new financial transaction duty will put a further burden on the banking sector.
The AGS priority of restoring normal lending to the economy therefore remains a
challenge.

Finally, Hungary's structural reform programme is expected to
translate to sizeable fiscal consolidation from 2012. Some elements of this
package are supportive of growth, and others have the potential to be so; for
instance, the reform of the transport sector has the potential to achieve
sizeable fiscal gains while also improving its efficiency and performance. Although
not fully reflected in the NRP, current reform plans in the healthcare sector
also have the potential to improve fiscal sustainability. Overall, however, the
policy mix is regressive and is not in line with the AGS priority of
differentiated growth-friendly fiscal consolidation. On the whole, progress
towards reducing the high public debt ratio is very much needed. The result of
high fiscal deficits, especially in the 2002-2006 period, the structure and
financing of public debt is also a source of vulnerability given that close to
half of it is denominated in foreign currency (and close to 70% is owned by
foreign residents).

Box 1: Summary of
the results of the in-depth review under the macroeconomic imbalances procedure

Hungary's economy built up sizeable external and internal
imbalances in the years leading up to 2009 and it now faces a continued
adjustment challenge. The
high public debt stock and high negative Net International Investment Position
(NIIP) (81.3% and -112.5 of GDP in 2010, respectively) are primarily the result
of the continuous twin deficits  recorded in the years before the global
economic and financial crisis (fiscal adjustment was initiated in mid-2006, but
from a very high deficit level). Over this period, Hungary's cost
competitiveness had been deteriorating in particular vis-à-vis regional peers.

With
the deep crisis, a sharp adjustment has taken place with the country's net external balances, but important
vulnerabilities remain. Starting from late 2008, the current account rebounded into a surplus
as domestic demand collapsed and corrective steps were taken also in the
context of a EUR 20 bn EU-IMF financial assistance programme. It was also
supported by the significant improvement in cost competitiveness through mainly
the depreciation of the forint and a decline in real wages. The Commission
services' Spring 2012 forecast points to further steep reduction in the NIIP to
well below 90% of GDP by the end of 2013. Public debt
sustainability calculations prepared by the Commission services show that a
firm decreasing path for public debt is attainable in the coming decade, but
continued tension in the financial markets could relatively easily reverse this
trend. The resolute decrease in public indebtedness is all the more important as
rolling over such a high gross debt stock always implies increased
vulnerabilities. The associated risks have prompted the national authorities to
seek a precautionary financial assistance from the EU and the IMF, on which
negotiations are yet to start.

At
the same time, Hungary's medium-term growth outlook is modest at best, partly
as a consequence of policy uncertainty. The potential growth is currently estimated to be
considerably lower than what is expected for neighbouring countries: in the
range of 0.2-0.4% for the 2011-2013 period. The persisting concerns over the
country's long-term potential growth are to a large extent due to labour market
weaknesses and a historically low level of investments. These bottlenecks to
growth are also linked to the significant decrease in FDI inflows starting from
2009, also linked to a fall in reinvested profits. The low level of economic
confidence is explained first by the crisis but more recently by significant
(and often controversial) changes in the policy environment.

The high stock of private debt (at 155% of GDP) stands out among
catching-up economies. Despite the recent rapid deleveraging, its currency composition
(according to financial accounts data over 60% is denominated in foreign currency) is still a source of concern, which in turn contributes to
the important strains on Hungary's strongly interconnected banking sector. The
recently experienced high CDS sovereign spreads has a host of negative
implications for economic prospects and contributed to the increasingly high
financing costs of the real sector.

In
this context, the policy response could usefully include creating the
conditions for sustained macroeconomic growth as well as a gradual but
sustained deleveraging of both private and public agents. This should also make the country less
vulnerable to changes in market sentiment and restore its attractiveness for
foreign direct investment. Policy initiatives could therefore target the
creation of a predictable policy environment and well-functioning institutional
system, which should be conducive to the sustained reduction in stock
vulnerabilities. In addition, structural reforms in both labour and product
markets are worth pursuing in order to lift the country's potential growth.

              3.       Assessment of policy agenda

              3.1. Fiscal policy and
taxation

Budgetary developments and debt dynamics

The 2012 convergence programme confirms the deficit path laid down
in the 2011 update of the convergence programme, i.e. deficit targets of 2.5%
of GDP in 2012 and 2.2% of GDP in 2013. The deficit is planned to decrease
further to 1.5% of GDP by 2015. In parallel, the (recalculated) structural
balance[3]
will improve from 4.0% of GDP in 2011 to 1.9% of GDP in 2012 and 1.2% of GDP in
2013 and slightly further in 2014 and 2015. This means that the
medium-term-objective (MTO) of a deficit of 1.5% of GDP, which is unchanged
compared to the target defined in 2011 and adequately
reflects the requirements of the Stability and Growth Pact, would be achieved in 2013, i.e. the 2012 convergence programme
aims to achieve the MTO two years earlier than planned in the 2011 convergence
programme.[4]
This deficit path would also bring the deficit below the threshold of 3% of GDP
by 2012 and beyond.

In 2011, the headline general government balance reached a surplus
of 4.3% as against a surplus of 2% of GDP targeted in the 2011 convergence
programme. According to the Commission services calculation, the 2011 convergence
programme at the time included a headline 2011 deficit net of one-offs of close
to 6% of GDP, while  based on the 2011 budgetary outcomes, the headline deficit
net of one-offs was around 5¼% of GDP[5],
i.e. better than expected by close to ¾% of GDP. This better outcome is mainly
explained by the small surplus of the local government sector compared to an
expected deficit (0.5% of GDP) and some savings measures in the course of the
second half of the year (around 0.2% of GDP), such as the increase in excise
duties and expenditure cuts in the budgetary chapters. Regarding the one-offs,
on the revenue side the value of the transferred pension assets was higher by
0.7% of GDP than the 9% of GDP expected in the 2011 convergence programme. The
headline deficit also improved by close to 1% of GDP due to changes regarding
one-off expenditures since the debt assumption and PPP buy-backs (together close
to 2% of GDP) eventually did not take place[6]
and this was only partly counterbalanced by additional one-off expenditures.[7]

Regarding 2012, the attainment of the official deficit target of
2.5% of GDP is supported by further savings measures (of around 1¾% of GDP,
according to the Commission services calculation)  compared to the 2011 convergence
programme, which are intended to counterbalance some expenditure slippages and
revenue shortfalls, partly related to the worse than expected economic growth
developments.[8]
These further savings reflect exclusively revenue increasing measures, such as
the hike of the standard VAT rate from 25% to 27% as well as some recently
announced tax increases (e.g. a permanent levy on telecommunication services.
The expenditure cuts (e.g. reduction of expenditures in the budgetary chapters,
partly announced in the 2012 convergence programme) were fully counterbalanced
by expenditure increasing decisions (e.g. outlays related to the mid-December
2011 agreement with the banking sector as well as the extension of the public
work programme).

According to the Commission services' 2012 Spring Forecast, the 2012
deficit target is foreseen to be reached. However, this forecast includes net one-offs
amounting to around 0.9% of GDP (mainly related to the temporary sectoral
levies). Without these temporary factors the budget deficit would be close to
3½% of GDP. This forecast assumes the elimination of the (full amount of)
extraordinary reserve of close to 1½% of GDP, which was created to compensate
for unforeseen developments in order to ensure that the deficit target can
still be met.[9] 
In contrast, the convergence programme still assumes the availability of an extraordinary
reserve of 0.4% of GDP in 2012. This difference is on account of the
expenditure slippages of close to ½% of GDP expected by the Commission services
related notably for pharmaceutical subsidies and the transport sector.

In 2013, according to the 2012 convergence programme, without taking
additional measures and also in view of the phasing out of the extraordinary
sectoral levies of close to 1% of GDP, the budget deficit would be expected to
reach 3.6% of GDP, i.e. be higher than the deficit target by close to 1½% of
GDP.[10] 
This is in line with the deficit forecast underpinning the Council
recommendation to Hungary of March 2012 in the context of the excessive deficit
procedure. Against this background, the 2012 convergence programme lists
additional revenue-increasing[11]
and expenditure savings measures of around 1.7% of GDP (for details see Box 2 below).

Also taking into account the implementation risks partly due to the
lack of sufficient specification mainly on the expenditure side, around two
thirds of this deficit improving effect of 1.7% of GDP (i.e. 1.1% of GDP) could
be incorporated in the Commission services' 2012 Spring Forecast. Whereas the
2012 convergence programme forecasts that the deficit target of 2.2% of GDP
will be achieved while preserving an extraordinary reserve of at least 0.2% of
GDP[12],
the Commission services' 2012 Spring Forecast projected a deficit of 2.9% of
GDP without any extraordinary reserve left. This higher deficit forecast,
beyond the implementation risks related to the saving measures, also reflects a
worse macroeconomic outlook.

It may be useful to note that the consolidation steps raise some
questions in terms of quality, as they are mainly concentrated on the revenue
side and may hinder economic growth also in the light of the deteriorating business
environment due to the de facto replacement of temporary sectoral levies that
were supposed to be phased out by permanent sectoral taxes largely in the same
sectors.

Following the cut-off date of the 2012 Spring Forecast new
information became available. The government provided further details on the
cuts to appropriations of the budgetary chapters[13] as well as the decision
to nominally freeze the expenditure of the central budgetary sub-system for the
purchase of goods and services in 2013 was made public (with a combined budget
improving impact of 0.2% of GDP). Finally, on 11 May the government also submitted
to Parliament a tax package containing a number of elements that differed from
the description in the 2012 convergence programme. Some of the parametric changes
(e.g. lower-than-planned tax hike for the surcharge on energy and public
utility companies) entail a combined revenue loss of close to 0.1% of GDP,
which is estimated to be compensated by correspondingly higher receipts from
the financial transaction duty. Taking into account all of this new
information, the 2013 deficit is projected to fall to 2.7% of GDP.

|| Box 2. Main budgetary measures ||

|| Revenue || Expenditure ||

|| 2011 ||

|| Introduction of the flat PIT system (-1.8% of GDP) Full-year effect of CIT cut (-0.25% of GDP) De facto elimination of the earlier mandatory private pension pillar (one-off: +9.7% of GDP, permanent: +1.3% of GDP) || Cut in appropriations for budgetary chapters (-0.8% of GDP) Debt assumption of MAV (+0.2% of GDP) Capital injection in the MFB (+0.1 % of GDP) Reimbursement of VAT based on EU Court decision (+0.7% of GDP) Outlay related to the agreement with the banks (+0.2% of GDP) ||

|| 2012 ||

|| Maintenance of the financial sector levy at its original rate (+0.3% of GDP)  Hike in the VAT standard rate from 25% to 27% (+0.5% of GDP) Increase in the SSC paid by employers (+0.4% of GDP) Introduction of a tax on telecom services (0.1% of GDP) Other tax increases (0.8% of GDP) Net effect of the reform of PIT (+0.3% of GDP) || Nominal wage freeze in the public sector together with wage compensation (-0.1% of GDP) Reduction of unemployment benefit and sick pay (-0.4% of GDP) Review of the pension system (-0.2% of GDP) Restructuring of public transport (-0.1% of GDP) Reduction in the drug subsidy (-0.3% of GDP) Improved efficiency of the public sector (-0.2% of GDP) Cut in the appropriations for the budgetary chapters (-0.8% of GDP) Outlay related to the agreement with the banks (+0.4% of GDP) Wage compensation in the private sector (+0.4% of GDP) Extension of the public works programme (+0.2% of GDP) Increased subsidy for the national railway company (+0.2% of GDP) ||

|| 2013 ||

|| Maintenance of the higher CIT rate  (0.3% of GDP) Phasing out of the extraordinary sectoral levies (-0.9% of GDP) Narrowing of the tax base of PIT (-0.3% of GDP) Introduction of a financial transaction duty (at least 0.4% of GDP) Higher tax rates on insurance services and the energy sector (0.2% of GDP) Full yearly impact of the tax on the telecom sector and the reverse charge VAT in agriculture (0.1% of GDP) Introduction of the electronic road toll (0.25% of GDP) || Outlay related to the agreement with the banks (+0.2% of GDP) Further savings in the pension system (-0.1% of GDP) Further cut in the drug subsidy (-0.3% of GDP) Increased efficiency of the public sector (-0.3% of GDP) Further extension of the public work programme (+0.1% of GDP) Lower wage compensation in the private sector (-0.1% of GDP) Increased salaries in the public education sector (0.1% of GDP) Cut in the support for the state-owned enterprises (-0.1% of GDP) Lower support for the Research &Development fund (-0.1% of GDP) Freezing of expenditure on the purchase of goods and services in the public sector (-0.2% of GDP) ||

|| 2014 ||

|| Full year effect of the electronic road toll (0.25% of GDP) || Outlay related to the agreement with the banks (+0.2% of GDP) Increased salaries in the public education sector (0.4% of GDP) ||

Note: The budgetary impact in the table is the impact reported in the programme, i.e. by the national authorities. A positive sign means that revenue/expenditure increases/decreases as a consequence of the measure. The degree of detail reflects the type of information made available in the convergence programme.

The (recalculated) structural balance is foreseen to improve by 2.1%
of GDP in 2012, following a deterioration of 1.4% of GDP in 2010 and 0.3% of
GDP in 2011. In 2013, the (recalculated) structural balance improves by 0.7% of
GDP, which would demonstrate adequate progress towards the MTO. Furthermore,
the medium-term-objective (MTO) of 1.5% of GDP, which is unchanged compared to
the target defined in 2011, would be achieved in 2013. This also means that,
according the (recalculated) structural balance, the MTO, in contrast with the
2011 convergence programme, would be achieved in the course of the programme
period, mainly in view of the outlook for lower economic growth while the
deficit targets are kept. However, according to the Commission services
assessment, the structural balance will improve only by 0.3% of GDP to 1.8% of
GDP. This means that progress towards the MTO does not appear to be adequate in
2013 based on the assessment of the Commission, which takes into account the
implementation risks associated with selected savings measures and a less
optimistic macroeconomic scenario.

The expenditure benchmark, according to the programme, will be met
in 2013. However, real public expenditure growth will exceed the reference
value in 2014 and in 2015 in the light of the assumption that economic growth
will exceed the medium-term potential growth estimated by the Commission
services based on the agreed method.

The baseline scenario incorporated in the 2012 spring forecast is subject
to symmetric risks. Risks pointing towards a higher deficit (e.g. higher
subsidies for student and housing loans, potential reimbursement of losses of
the central bank as well as risks related to the accumulated debts of public
enterprises and the many expenditure cuts targeting the same budgetary
chapters) may be off-set by deficit decreasing risks, such as more favourable
than currently assumed balances of local governments and potentially increasing
risk appetite, reducing interest expenditure.

According to government plans, the public debt will be continuously
reduced throughout the programme period to 77% of GDP in 2013 and below 73% of
GDP in 2015, but will remain above the 60% of GDP reference value. Regarding
the debt reduction benchmark, Hungary will be in transition period in 2013 and 2014,
and plans would ensure sufficient progress towards compliance with the debt
criterion. Moreover, according to the plans, the debt benchmark will be met at
the end of the transition period, in 2015. At the same time, according to the
Commission services' assessment and assuming that no public assets will be sold
in 2012, the debt ratio will decrease less dynamically, only to 78% of GDP by
2013.

Long-term sustainability

The projected long-term change in age-related expenditure is below the EU average. The initial relatively favourable
budgetary position offsets the increase in long-term costs. Based on
simulations prepared by the Commission services, under a no-policy-change
assumption, debt would fall to 74.8% of GDP by 2020. Additional fiscal
consolidation beyond the forecast horizon would be needed to make progress
towards the reference value for government debt beyond the short term. However,
the full implementation of the programme would be enough to put debt on a
steeper downward path by 2020, even if it would still be above the 60% of GDP
reference value in 2020. Ensuring sufficient primary surpluses over the
medium-term would improve the sustainability of public finances.

Fiscal framework

After some initial signs of success with the previous budgetary
framework, it was fundamentally revamped by the current government, which has
weakened some aspects of the efficiency of its operation while strengthening
others. The new Basic Law that came into effect on 1 January 2012 prohibits the
adoption of a budget that would lead to public debt exceeding 50% of GDP. Until
the debt ratio falls below this level, only budgets inducing a reduction in the
debt ratio may be adopted. The competence of the Constitutional Court in
legislation with budgetary implications remains restricted until the debt
ceiling has been met. Rules for convergence to the debt ceiling and operational
rules concerning the Fiscal Council were specified in the Economic Stability
Law adopted in December 2011.[14]
Finally, the new Public Finance Act includes important (to a large
extent re-confirmed) provisions for budgetary planning with both an annual and
a medium-term planning horizon.

Overall, the new Basic Law of Hungary and the legislative documents
discussed above lay out a fiscal governance framework for Hungary that has a number of merits. The new set-up makes it virtually impossible to
adopt a non-compliant budget act in economically good times; the semi-annual
review offers the possibility of correcting ex-post increases in public debt
beyond the admissible level and a fiscal council occupies a key position in the
process of budgetary planning. The accumulation of debt at local government
level is now subject to central control. With the respective provisions in the
Public Finance Act, the rudiments of a medium-term budgetary planning framework
have been established.

Nevertheless, a number of flaws remain in
the new institutional framework, notably regarding the design features of
the debt reduction rule. First, although the rule is anti-cyclical,
there is no immediate relation to the output gap, so it may or may not result
in an outcome that is consistent with a structural budget balance constraint. Second,
the legislation does not give guidance on the extent of admissible deviations
from the debt constraint in the event of a significant economic recession
(escape clause). Third, although an instant interim review is foreseen if
debt reduction has exceeded the established limit and mandates budgetary
correction, no deadline is established for such a review. Finally, the debt
reduction rule might not ensure compliance with Hungary's obligations regarding
the speed of debt reduction (also due to the difference in debt definitions) and
adherence to the medium-term objective.

Regarding effective budgetary planning the government is
explicitly granted the possibility to adjust the key figures in the outer three
years of planning the central budget at any time without further specifics, and
without any indication that these plans would provide the basis for the
preparation of the annual budget. Therefore the multi-annual character of the
fiscal rules is not yet guaranteed. With regard to the transparency of the
budgetary process, the rights to access information are not specified, the
timeliness of data publication is not stipulated and the dimension of public
awareness on budgetary matters is not appropriately considered.

As far as the FC is concerned, its
analytical remit and material resources as stipulated in the ESL are not
commensurate with its power to veto the annual budget law. As suggested by
international best practice, the quality and credibility of budgetary planning
would be increased by entrusting the FC with the preparation of the
macroeconomic forecast underlying the draft budget and medium-term planning as
well as with ex-ante impact assessment of major fiscal policy
initiatives (e.g. tax laws, also which are outside the standard budgetary
cycle). Even after March 2012, when the President of
the FC became entitled to a competitive remuneration and a small secretariat was
set up, the assignment of an appropriately sized and dedicated
analytical staff is warranted.

Against this background, the recommendations issued in July 2011
have been partly implemented. New regulations have been adopted for the
operationalisation of the new constitutional fiscal governance framework but
some weaknesses in its design can be identified. The adopted new annual
numerical rule appears to focus too much on the annual budgetary cycle and does
not seem to be conducive to medium-term budgetary planning, which remains indicative
in the new framework. Regarding the analytical remit and the resources of the
Fiscal Council, they are not commensurate with its newly granted strong veto
power. There is still a need to improve the availability of budgetary
information, also given that raising public awareness of budgetary policies
could contribute to the success of fiscal consolidation built on fiscal
consensus as well as to meeting the transparency requirements laid down in the Directive
on national fiscal frameworks.

Tax system

The tax burden in Hungary temporarily fell by 1.5 pp.
to 36% of GDP in 2011, but it is expected to increase to about 38.5% of GDP in
2012. This is close to the 2011 EU27 average of 39.2% but it is higher than in
comparable countries (e.g. SK (29.2%), EE (33.3%), CZ (35%)). In terms of the
taxes considered least distortive to growth, the share of consumption taxes was
already rather high in 2011 and is expected to increase further, while revenue
from recurrent property taxes remains below average.

Corporate income tax revenues fell as a result of a 2010 cut in the
corporate income tax rate from 19% to 10% on income below a certain threshold.
Personal income tax revenues also decreased due to the replacement of a progressive
system with a 16% flat rate system introduced in 2011. Furthermore, in 2011 a
new, generous and non-targeted family tax credit system was introduced with significant
allowances especially for those with three or more children. This was partly
financed from the 20% reduction in the employment tax credit available to low
to medium earners.

In the decade to 2010, Hungary was characterised by high labour
taxation, which specifically affected low wage earners (Hungary had the 4th highest tax wedge in the EU for single earners at 67% of the average
wage in 2010). Although due to the recent reform the
implicit tax rate on labour fell from 39.4 % in 2010 to around 35% in 2011, the
tax burden on labour remains high in Hungary. In 2012 the
PIT base for low to medium earners was narrowed, while at the same time the
employment tax credit was fully removed, leading to a further overall increase
in the tax burden on low earners. Thus the tax burden on
a single average-wage worker, for example, increased by 2.4 pps. It is also
worth noting that the social security contributions paid by employees were
increased by 1 pp. The increase in the tax wedge has reduced the incentives to
participate in the formal labour market for a significant proportion of the
labour force, in particular for low-skilled and secondary workers. In
comparison, the favourable labour market impact among high-income workers is
expected to be limited due to their already high labour supply.

In the private sector, a wage subsidy scheme providing a tax
allowance for employers who maintain net nominal wages has been introduced to
counterbalance the unintended adverse labour market effects (see also section
3.3). For public workers the government provide an automatic offset. The
budgetary effect of these counterbalancing measures is officially expected to
be around 0.6% of GDP. Moreover, the introduction of the flat tax has increased
the tax burden for those who have a higher propensity to consume and thus may
also deteriorate the short-term growth and fiscal dynamics. The maintenance
beyond 2012 of the wider PIT base for those on higher wages could generate some
savings compared to the current plans, which may allow some compensation for
lower earners in a budget neutral way. It is worth mentioning that this tax
allowance system make the tax system even more complex, contrary to the
original aim of the flat PIT.

A number of new consumption-type taxes, such as a tax on unhealthy
food and car insurance have recently been introduced, and several tax rates and
duties have been increased. The standard VAT rate has been raised from 25% to
27% (the highest in the EU). The temporary extraordinary levies introduced in
2010 on the retail, telecommunication and energy sectors are planned to be
phased out, while the financial levy is to be halved in 2013. However, the
introduction of a number of new permanent taxes was announced in the 2012
convergence programme, affecting practically the same sectors, such as the
financial transaction levy (0.45% of GDP), the tax on the telecommunication
services (0.15% of GDP) as well as increased surcharges on insurance services
and the energy sector (0.2% of GDP). Since the recent tax reforms have resulted
in a falling share of income taxes while consumption taxes have further increased,
the main issues at present are not the scope for further tax shifts to enhance
growth, but rather the unwanted behavioural impacts of the recent reforms,
which may undermine growth prospects, including the detrimental impact on the
investment climate of the extraordinary levies and their replacement by
permanent levies from 2013.

Revenue from recurrent property taxation in Hungary accounted for only 0.35% of GDP in 2009, while approaching the EU average (for the
19 Member States for which data are available) could provide additional revenue
of about 0.5% of GDP. Potential measures along these lines could be designed to
mitigate the negative impact on vulnerable households.

The horizontal screening of tax challenges points to concerns with
tax governance. The Hungarian tax system is characterised by significant tax
evasion as indicated by the large shadow economy and signs of undeclared work.
The size of the shadow economy is estimated at nearly 24%, i.e. substantially
above the EU average of 16%.  Underreporting is common as many Hungarians
declare an income at the minimum wage, although the prevalence of such underreporting
is likely to be lower than sometimes claimed (overstating the revenue impact
but understating the employment impact of a minimum wage hike)[15]. The self-employed have also
been found to practice underreporting. The government has recently taken
measures that go in the right direction, i.e. allowing unannounced audits and
increasing penalties.

              3.2. Financial sector

The financial indicators for the Hungarian banking sector remain
solid, although the aggregate figures mask significant divergences among banks.
No Hungarian financial institution was identified as
needing recapitalisation in the context of the temporary bank recapitalisation
exercise launched by the European Council of October 2011 and coordinated by
the European Banking Authority, but the non-performing
loan (NPL) ratio reached 13.5% and the share of corporate NPLs is among the
highest in the EU. The banking sector has been weakened by the lacklustre
economic performance, its exposure to foreign currency loans and unfavourable
policy measures. Several large banks are owned by foreign parent companies that
are themselves under pressure to meet regulatory and market capital requirements.
Credit to the economy has been contracting, in contrast with most
regional peers. Credit conditions have been particularly tight in the
enterprise sector, with the decline
in corporate lending having reached a four-year record in December 2011. Venture capital investments fell by more than 10% in 2011, the
highest negative rate in the EU27.

The
2011 Country-Specific Recommendations to Hungary called for assessing the
effectiveness of current SME support policies and adjusting public programmes to
improve access to non-bank funding. In line with this recommendation, Hungary reformed its JEREMIE programme in
order to increase both absorption and the leverage effect. In this context,
combined microcredit tenders have been introduced from spring 2011, providing
non-refundable grants combined with credit to micro enterprises. New calls are
also available in the area of seed/venture capital: investments financed from
venture capital more than tripled in 2011. By the end of 2011 more than EUR 200
million reached final beneficiaries under the JEREMIE programme (mainly public
money), and implementation has been accelerated through innovative instruments.
Guarantees in particular have had a notable multiplying effect.

Hungary also increased the allocation of
resources to business development in the framework
of the New Széchenyi Plan (NSzP). The Széchenyi Card Programme, modified in
2011, provides credit-card based, low-interest loans for micro-, small- and
medium enterprises at Hungarian credit institutions. Interest and guarantee fee
subsidies are also offered. So far more than 150 000 cards have been issued
with a credit line of about EUR 3.5 billion, and in 2011 the contracted amounts
increased by more than 8% in nominal terms. There remains a concern that young
innovative enterprises and start-up companies do not meet the criteria required
in the calls for non-refundable subsidies, although there are some legitimate considerations
behind this. For example, NSzP calls require applicants to have been in business
for at least two years, aiming to exclude companies that set up just to apply
for funding and then declare bankruptcy. However, start-up SMEs can also
benefit from the new combined micro-credit tenders and low-interest loans.

The implementation of the 2011 recommendation on SME policies has
therefore been mixed. The measures to improve
access to non-bank funding have been relevant and relatively ambitious compared
to the practice in the past. However, the effectiveness of current SME policies
has not been reviewed, although the NRP refers to revising the SME support system
at the end of 2010. Hungary has also not introduced any monitoring system for
assessing the impact of SME policies.

The measures described above in themselves support the AGS priority for
improving SME access to finance. However, the overall package of government
policies has not been conducive to the ultimate aim of restoring normal lending
to the economy. The financial sector levy approved by
Hungarian lawmakers back in 2010, of which 0.45% of GDP falls on banks, is the
largest in the EU (planned to be cut from 2013). Further,
the government unilaterally opened the possibility of early repayment of FX-denominated
mortgages at discounted rates in September 2011, which resulted in losses for
the banking sector in the order of 1¼% of GDP, and principally benefited a
relatively small group of rather well-off Hungarians whose mortgages were not in
arrears. The government reached an agreement with the Banking Association in
December also to reduce the losses of the banking sector on these loans,
although these still remained substantial (1/3 of these losses can be deducted
from the bank levy, resulting in a net loss from this
scheme of below 1% of GDP). Going
forward, a stable policy environment will be crucial in order to support the
resumption of lending activity. Broadening the range of eligible issuers of
domestic mortgage-covered bonds could also contribute to a more stable funding
structure and may promote lower interest rates for borrowers.

              3.3. Labour market,
education and social policy

The participation rate in Hungary has been increasing
over the past years due to policy measures introduced by the current and the
previous government, but it still remains among the lowest in the EU (HU: 62.7%,
EU 71.2% in 2011). Unemployment has been in the double digits (10.9% in 2011)
and is projected to remain so over the forecast horizon. As outlined in section
2.2, the employment rate of the Roma, of the low-skilled and of the young is
particularly low and social inclusion is lagging.  Women's share of the total
volume of hours worked is the 6th highest in the EU, but their
participation in the labour market is still hampered by the fact that available
childcare capacity falls well short of the actual and potential demand: in
2010, the capacity utilisation of crèches was 110%, and coverage is
particularly scant outside of large cities. Maternity leave, at up to 3 years,
is uniquely long.

The geographical and occupational mobility of the labour force is
poor. The contributing factors include a high proportion of house ownership,
regional differences in rental prices and the lack of an efficient and deep
residential rental market, and a low participation rate in life-long learning.
In addition, according to the Hungarian Chamber of Commerce, the proportion of
vocationally trained workers who are either unemployed or working in fields
that do not correspond to their professional qualifications is around 60%,
suggesting a mismatch between labour market requirements and the skills
acquired in the educational system. State contributions and grants for school education have been cut, although already in 2010 the total amount was only 80% of the
2006 figure. Hungary's global ranking on the training
of education staff, at 111th place, is extremely low[16].

As reflected in the NRP, the government has introduced numerous
reforms in the labour market over the past year. These include tax changes, a
drastic cut in the unemployment benefit to 90 days that came into effect in
September 2011 and tightening other benefits, a new labour code (which is being
scrutinised by the Commission and which especially initially proved to be an
unfavourable example of downplaying social dialogue), and piloting vocational
training under the new system devised in consultation with the Chamber of
Commerce. At the end of 2011 new laws were also adopted on public, vocational
and higher education. The pensionable age has been raised by three years and
early retirement abolished (without adequate labour demand and complementary
retirement savings, the future adequacy of the pension system and therefore the
possible hidden liabilities for the public budget may require attention).
However, progress towards meeting the country-specific recommendations has
been limited and the recommendations have only been implemented in part.

With respect to the 2011 recommendation on activation policies, the
participation rate has indeed been rising (from 62% (2009 Q4) to above 63%
(2011 Q4) in the 15-64 age group) in parallel with the drastic tightening of
social assistance schemes and the unemployment benefit. At the same time, the
measures to alleviate the impact of the tax reform on low earners have
been far from ideal. The full elimination of the employment tax credit in 2012,
combined with an increase in social security contributions, has further
aggravated the situation of low earners: those without children who take home
less than the average wage can ceteris paribus be facing an over 10% drop in
their wages compared to 2011.

To ameliorate these developments, the government raised the minimum
wage by around 19% and introduced employer wage subsidy schemes. However, this
convoluted system, whose elements are set out in the NRP, does not necessarily
offer relief to low earners other than at the minimum wage, and it renders the
marginal tax rate the highest at low incomes. The minimum wage raise is also
likely to be unfavourable for labour demand and it may increase grey
employment, inflationary pressures and expectations of a weakening exchange
rate. (On the upside, the legislation introduced the possibility to
differentiate the minimum wage by region.) The wage subsidy schemes, which in
any case may be temporary, do not offset all of the resulting burden on
companies and employees, even leaving aside the administrative costs and the
additional costs that may be involved if approximate wage ratios between
different wage levels are maintained. Moreover, this scheme, as long as it is in
effect, deteriorates the budgetary balance

The NRP describes steps that have been taken to
encourage women's participation in the labour market: e.g. the new labour code encourages flexible
working arrangements, as well as easing the conditions of return of new parents
to the labour market. Progress
on expanding childcare has been meagre, mainly due to the lack of funding (it
is relevant to know here that the child tax allowances and the child benefits
are not means-tested). The pressures on the system, especially in regions characterised
by more favourable demographic trends, will only increase since the mandatory
age for kindergarten participation was lowered from five years to three (taking
effect in 2014). Support for alternative childcare services from EU sources (ESF)
has been increased from HUF 6 bn to HUF 8 bn, but the overall amounts are
small, while the sustainability of institutions established mainly from EU
(ERDF) funding is challenging given that the responsibility for operational
costs remains with local governments.

The policy responses to the 2011 recommendation on activation
policies therefore have only been partially relevant to the extent that the
instruments chosen to address the impact of the tax reform on low earners have
been suboptimal, while the measures to strengthen women's participation in the
labour market are a very small step in the right direction and they are too
limited to have a significant impact. The policy instruments cannot be
considered ambitious since their scope is rather limited in comparison to the
challenge. .

Regarding the 2011
recommendation on active labour market policies, the Public
Employment Service has been reorganised again as of January 2012, including
a merger with the Office for Labour Supervision and the National Institute for
Vocational Education. This has brought with it a downsizing in the Public
Employment Service, whose capacity has already been under pressure given high
unemployment since the crisis. In parallel, a National Rehabilitation Authority
is being set up to become operational in July 2012, with the staff to be drawn
from the local Public Employment Service offices. Furthermore, half of the institution's
overall capacity is now committed to managing the new public work scheme.
Rather than strengthening the capacity of the Public Employment Service,
therefore, developments are pointing in the opposite direction.

Active labour market policies are also
undergoing large-scale restructuring, with cuts in training expenditure but
doubling the funds allocated to public works compared to 2011. However, there
is no comprehensive evidence-based evaluation of running active labour market policies that would
back these changes. Insofar as training programmes may have been relatively
ineffective, it would have been preferable to improve the provision of training
instead of cutting down on it. It would also be
desirable to facilitate mobility support (as also encouraged by the
Commission's Employment Package). The public works
scheme serves the double purpose of targeting social
inclusion and activation, but the latter element should be strengthened in
order to increase the chances of finding employment in the open labour market. Conducting
job search is difficult for participants when most employment in the public
works scheme is full time (as of this year), without making allowances for this
within the structure of the public works scheme. There is a risk that the
drastic cut in unemployment benefit, together with the reduced capacities of
the Public Employment Service, will result in channelling and locking people in
to public works.

A new European Social Fund active labour market programme for
integrating disadvantaged groups has been launched, with some
modifications relative to the previous such programme. In regions with a high
proportion of low skilled inhabitants and long-term unemployed, more focus will
be given to training, counselling and job search assistance. The indicators set
for this four-year programme are evidence based and there is close monitoring.
The Social Renewal Operational programme is also being modified to increase the
allocation to active labour market policies and life-long learning, general foreign language and IT training
and on-the-job training programmes. A new programme is being set up to help
disadvantaged people develop life management skills.

In sum, there has been no progress towards meeting the
recommendation regarding the Public Employment Service. Some of the measures
aiming to provide tailor-made services for disadvantaged groups are relevant
(the European Social Fund programmes), others are ambitious insofar as the
activation of some disadvantaged groups is concerned, but unlikely to be
effective in improving the placement of participants in the open job market
(public works). In the absence of a comprehensive evaluation of active labour market policies provision,
there has not been much progress in linking funding to results.

In terms of AGS priorities, Hungary has embarked on important
advances in supporting employment, including of young people. The government’s
youth policy framework programme (New Generation Programme) was approved at the
end of 2011, with an emphatic element on improving youth employment. Vocational
education and training is being revised to better respond to skills demand in
the labour market, and rigidities of contracts have been reduced. It should
nevertheless be noted that the reduced attention to elementary, general skills
in vocational education could become a concern without significant and coordinated efforts in parallel to improve
the output of primary education given the current poor state of affairs and the
fact that employers seek adaptability.[17]
The Dobbantó pilot project helping pupils in need to catch up appears to be
successful. Mainstreaming its features into the Bridge Programme framework
would be promising from an educational point of view, but this cannot happen
without appropriate funding and the NRP does not foresee additional resources
for this purpose.

Funding for tertiary education has been cut given the need for
fiscal consolidation. Science and mathematics placements have been privileged
within this context, but raising the overall tertiary attainment rate should
remain a priority since, at 25.7%
in 2010, it is well below the EU average and the NRP target. As students from
lower socio-economic backgrounds tend to be more averse to taking on financial
risks, it would be important to monitor their participation in the student loan
scheme. In addition, elements of the new legislation on school education risk
increasing the number of early school leavers and further segregation in the
Hungarian school system, while the low participation
rate in lifelong learning hampers competitiveness and labour market adaptation. Progress has been mixed in mobilising labour for growth. The
activity rate has been increasing, but several sectors with the highest
employment potential (‘white jobs’ in the health and social sectors) are
chronically underfunded and a forward looking health
workforce strategy would also be important to retain healthcare professionals
to meet the growing demands of healthcare. There is also
room to improve the promotion of entrepreneurial skills.

Finally, Hungary recent policy record in protecting the vulnerable is in sharp contrast to the AGS
recommendations. The effectiveness of social protection systems decreased,
while the share of the population at risk of poverty or exclusion increased
from 28.2 in 2008 to 29.9% in 2010, and the proportion of those affected by
material deprivation from 17.9 in 2008 to 21.6% in 2010.[18] In the absence of the EU-IMF
balance of payments assistance, the crisis would likely have been much worse
and these indicators could have risen yet further. In the context also of the
fact that Hungary's child poverty rate is about 1.5 times the EU average, the
higher emphasis on early childhood development in the Social Inclusion Strategy
(submitted on 6 December 2011) is welcomed but, together with other important
elements in the text, it is not reflected appropriately in the accompanying
action plan and in mainstream policies[19].
As a bright spot, investments are in the pipeline from EU funds in developing
social infrastructure and integrated action in favour of marginalised
communities (e.g. the Roma). However, a monitoring system is yet to be
launched.

              3.4. Structural measures promoting growth and
competitiveness

Hungary's ranking in the Global Competitiveness
Index has advanced from 58th position in 2009-10 to 48th
in 2011-12, but there remains considerable scope to improve. Cost
competitiveness had been considerably declining before the crisis, but then
improved on the back on the depreciation of the forint and a decline in real
wages. Albeit Hungary continuously gained market share before 2009, its
performance lagged behind regional peers. The relative resilience of the export
sector to declining cost competitiveness may be linked to the very significant
share of high-technology goods (at over 22% of total exports, one of the
highest in the EU-27).

Research and innovation

As the NRP also notes, R&D expenditure in Hungary (1.16% in 2010) is significantly below the EU average. Unhelpfully from the point
of view of incentivising R&D in the private sector, the direct costs of
research and development can no longer be deducted from the innovation tax payable
by enterprises. Coordination between the authorities responsible for different
tasks does not appear effective, as reflected for instance in the significant
delay in the preparation of the new R&D&I strategy, and predictability
in funding rules has not yet been achieved. On the positive side, several
schemes, discontinued after June 2010 and co-financed from the EU Structural
Funds, were reopened in 2011. According to the NRP, Hungary is preparing to
position itself for fully maximising EU funds and programmes in the next
funding period.

Hungary ranks as a moderate innovator in the Innovation
Union Scoreboard with a performance below EU average, with business R&D
investment driven primarily by foreign-owned enterprises. In terms of indicators
of SME innovation (introducing a new product or a new process), Hungary ranks among the lowest in the EU together with Latvia. In patent statistics, Hungary is ranked 16th among the Member States with 1.3 PCT patent applications
per billion GDP (compared to the EU average of 4), and the trend is slightly
decreasing. Human resources for research are currently projected to be
insufficient by 2015, although the number of students in maths, science and
technology supported from public sources will increase significantly according
to the new tertiary education act. Researcher mobility has long been low
both in terms of inter-sectoral and cross-border mobility. In 2010, foreign
researchers employed in Hungary accounted for only 3% of the total number of
researchers.

Internal market, liberalisation and competition

Several postal services remain significantly shielded from
competition, particularly in the letter mail segment, despite gradual market
opening introduced by the Postal Services Directives and implemented by the
Postal Act in Hungary. Excessively restrictive licensing requirements
introduced into the national regulatory framework are widely perceived to be
the main reason behind the lack of actual entry into the letter mail delivery
service, and limited entry into related market segments despite interest by
various market actors. Furthermore, the effect of the recent amendment of the
2003 Postal Act will be a de facto re-monopolisation of integrated mail, which
is an added value service that is currently provided freely on the market. This
is a significant step backward as the measure carries a strong negative signal
value for further potential entrants in other segments as well.

Competition is lagging in the professional services. Among the
21 Member States included in the Organisation for Economic Cooperation and Development
regulatory index on professional services, Hungary is the fourth worst ranked.
Despite the judgments of the CJEU of 24.5.2011 (concerning 8 other Member States), Hungary refused to repeal the nationality requirement for the profession of notary. In the retail
sector, Hungary now prohibits the establishment of new large scale retail stores and has imposed
excessive licensing requirements for issuing hot meal vouchers (de facto
restricting the market to nation-wide banks), while a state monopoly has been
imposed on issuing cold meal vouchers.

Infrastructure and public investment

Structural and
Cohesion Funds co-finance a substantial part of the investments included in the
New Széchenyi Plan (adopted in January 2011). The planned aggregate public
investment to be co-financed in the 2007-2013 period amounts to EUR 29.7
billion. The implementation and delivery system of the Economic
Development Operational Programme as well as the planning and monitoring
system can be considered effective, although highly centralised within one
single National Development Agency. Following a successful reorganisation,
implementation appears to be back on track. In 2011 an ambitious initiative was
carried out to streamline the delivery system, particularly with regard to aid
to enterprises: applications can now be submitted more easily and quickly,
which contributes to the acceleration of implementation. At the same time
however, improvements are needed in the public procurement system, where real
competition needs to be ensured.

On 22 March 2012, the European Commission referred Hungary to the Court of Justice of the European Union over the extraordinary levy on the
telecom sector. Increasing the financial burden of telecoms operators, as
indicated in the 2012 Convergence Programme, is likely to impede investment in
a sector expected to drive growth under the Digital Agenda. The digital switchover is currently
expected only at the end of 2014 instead of 2012, although making spectrum available for wireless broadband could help reduce
the digital divide, introduce more choice in broadband, and enable innovation
in other sectors.

Regarding transport, the liberalisation of the rail freight
sector has not advanced fast enough and the market share of the incumbent
remains above 80%. Travel times with the Hungarian Railways have been gradually
increasing because of the growing number of speed limits due to the state of
the tracks, which is the result of a long period of underspending on
maintenance. Almost ¾ of the railway company’s rolling stock is out of date,
and the technical assets of the Budapest Transport Company have reached the
limits of their utility: 85.2% of them have been used beyond their planned
lifetime.[20]
The NRP contains plans to renew the outdated vehicle park and establish an
electronic ticketing system with the use of EU funds.

There has been limited progress towards at increasing the efficiency
of public transport and reducing its dependence of public funding, although the
convergence programme rehearses previous goals and outlines some measures. The
lack of progress in restructuring public transport has been an important reason
for budget slippages in recent years.[21]
According to the convergence programme, an electronic road toll system is now
planned to be introduced by July 2013. A recent positive development has been
the introduction of competitive tendering for bus services in Budapest. As
regards inland waterways, over 30 bottlenecks hamper traffic on the Danube, with
an impact on the whole Danube transport corridor. The reallocation of funds
previously earmarked for improving inland waterways, as indicated in the 2012
NRP, would compromise the navigability of the Danube.

Energy and the environment

Environmental protection was not mentioned in the NRP, but the
potential of improving waste management could be explored both from a
growth enhancing and an environmental point of view. Full implementation of the
existing legislation could create more than 13 000 jobs and increase the annual
turnover of the waste sector by nearly €1.400 million.[22] Hungary is on track to
overachieve its CO2 emission reduction target by 36.2%
compared to the base year. Nonetheless, Hungary is not exploiting the growth
potential that moving towards a low-carbon economy could unlock, as energy
intensity remains high by EU standards and the NRP pays relatively little
attention to R&D. Following through on the ambitious energy sector plans
reflected in the National Energy Strategy (October 2011) would help limit
energy dependence for growth, particularly in industry and from transport. It
would be beneficial develop a long-term roadmap and a consistent monitoring
mechanism in order to make sure that progress is achieved as planned.

The independence of the energy regulator is not ensured and
it is not yet equipped with adequate means to independently set network tariffs
and to fulfil its tasks and responsibilities as defined in the Third Energy
Package. Subsidies are not currently targeted to vulnerable consumers, which
translates to an environmentally harmful subsidy to energy consumers. Moreover,
the current cross-border capacities in gas and electricity are not sufficient
to ensure the integration of national markets on a regional level, which would
boost competition and improve the resilience of the energy sector to external
supply shocks. Hungary will require investment into its energy infrastructure
but the current regulatory environment discourages private companies from
making investments, which may in the future put additional pressure on public
finances.

              3.5. Modernisation of
public administration

Institutional aspects rank high among the
most problematic factors for doing business in Hungary, and are the single worst performing
indicator in the Global Competitiveness Index. Corruption is the fourth most
important concern among respondents to the Competitiveness Survey, and the
burden of government regulation places Hungary 135th out of 142
countries surveyed.[23] As indicated in the NRP, the most recent estimate for the overall administrative
burden on firms is over 10% of GDP. Still, progress over the past decade has
been remarkable in some specific areas: starting business costs dropped from
over 100% of income per capita in 2002 to under 10% in 2011.

As set out in the NRP, the Simple State Programme (launched in the
second half of 2011) aims at reducing the administrative burden significantly, targeting
savings of 1.7% of GDP in 2012 alone. Implementation is at risk of delay as
responsibilities have not been clearly defined and the evaluation of the first
set of measures has not been delivered yet.[24]
Some elements of e-government such as the single document management are now
being applied in a limited way, and points of single contact have been set up,
although the Hungarian e-portal does not yet allow for the completion of all
administrative procedures. In the context of the Magyary Programme, the total number of public administrative bodies has
been reduced from 649 in 2010 to 318 mainly through integration many
responsibilities were transferred from the local government level to the state,
and one-stop shops for citizens were created at the county level. It is
important to guarantee an adequate local regional partnership in the
implementation of development programmes, mainly regional operational
programmes within the Cohesion Policy.

As far as tax measures are concerned, a number of new taxes have
been introduced whose administrative impact is likely to be high compared to
the revenues generated (e.g. on unhealthy packaged food and on pornographic
content). The complexity of tax rules on the whole affects firms of various
sizes differently: the government estimates that larger firms devote on average
1% of their turnover to the administration of taxes, while the same figure is
near 10% for small enterprises.[25]
The compensation mechanism to alleviate the increased PIT burden on low earners
further risks offsetting the potential administrative simplification gain
associated with the introduction of the flat PIT rate. Importantly, rapid
lawmaking in itself also exacerbates the administrative burden. An aspect of
this is the extensive practice of individual MPs submitting bills, thereby
circumventing the requirement of impact assessment.

In general, apart from the tax area, the envisaged measures are
relevant and go in the right direction, but implementation is lagging. The very
comprehensive public consultation procedure prior to adopting the programme
reflects good practice. Progress towards meeting the 2011 recommendation on
business administration, therefore, has been partial, and the size
of the challenge together with the high ambition of the plans point towards a
need for further close monitoring of the implementation in view of the
envisaged impact.

The 2012 Annual Growth Survey notes the importance of
improving the transparency and quality of public administration and the
judiciary. This is relevant for Hungary who ranks 64th on
judicial independence on the Global Competitiveness Index, with the Commission
having referred Hungary to the European Court of Justice regarding the
retirement age of judges on 25 April 2012 and administrative letters sent about
the independence of the judiciary in January and March. In terms of other
performance indicators, the length of proceedings and case backlog do not
appear to present major problems within the Hungarian judicial system.[26] Regarding public
administration, Hungary ranks 81st in the transparency of government
policymaking, 109th in the diversion of public funds, and 130th
concerning public trust in politicians. The German-Hungarian Chamber of
Industry and Commerce also reported in April 2012 that 87% of its respondents are
unsatisfied with the unpredictable
economic environment (the worst result compared to previous
years) and 62% rate
the erosion of trust in legal security
stemming from non-transparent legislation as the key factors behind declining
investor sentiment. This is also a concern since increasing FDI could be an
important channel for reducing the currently very high net international
investment position.

The scope to improve is therefore considerable, and recent
developments have been in the wrong direction. The weakest pillars of the
National Integrity System, as presented by Transparency International,[27] remain similar to the
situation under previous governments (e.g. political parties, the business
sector). However, the two-thirds majority won by the government in 2010 has
significantly relaxed the external constraints on appointments and the
reorganisation of institutions and rules. This has facilitated, for instance,
limiting the remit of the Constitutional Court, and rewriting the Basic Law
without genuinely broad consultation, which provoked strong criticism inter
alia by the Venice Commission and the EU. Party financing has also been a
long-standing concern: the State Audit Office only examines invoices submitted
by the political parties rather than assessing real expenditure. The lack of
control has the potential to seriously undermine anti-corruption efforts.

Finally, there is room to reinforce internal compliance mechanisms
as regards state aid. The number of prohibition decisions taken by the
Commission in the 2004-2011 period was the 8th highest in Hungary in
the EU (with the number of positive decisions taken into account for those
Member States who would otherwise tie in the rankings). The size of sectoral
(as opposed to horizontal) aid as a percentage of GDP, which can be an
unfavourable indicator of the quality of aid, was the highest in Hungary among
the Member States in 2010, although much of this reflects aid volumes granted
prior to accession, and set to end according to country-specific treaty
provisions. On the positive side, Hungary demonstrated the fourth highest level
of compliance with the State Aid Best Practices code.

              4.       Overview
table

2011 commitments || Summary assessment

Country-specific recommendations (CSRs)

CSR 1: Strengthen the fiscal effort in order to comply with the Council recommendation to correct the excessive deficit in a sustainable manner, inter alia by avoiding the structural deterioration in 2011 implicit in the planned 2 % of GDP budget surplus and ensure that the budget deficit is kept safely below the 3% of GDP threshold in 2012 and beyond, contributing to the reduction of the high public debt ratio. Fully implement the announced fiscal measures and adopt additional measures of a permanent nature if needed at the latest in the 2012 budget to secure the budgetary target for that year. The 2012 budget should also identify the additional measures in order to attain the 2013 target in the convergence programme. Ensure progress towards the medium-term objective (MTO) by at least 0.5 % of GDP annually until the MTO is reached and use possible windfall revenues to accelerate the fiscal consolidation.  || The government has achieved considerable progress regarding the implementation of the consolidation and structural reform measures included in the 2011 convergence programme and further saving measures 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. Whereas no effort was made to avoid the structural deterioration in 2011the fiscal adjustment is assessed to be sufficient to attain the official 2012 deficit target thanks to a structural improvement of over 2% of GDP. For 2013, the 2012 Spring Forecast projects a deficit of 2.9% of GDP, which could even be somewhat better based on most recent information. At the same time this deficit forecast assumes that all extraordinary reserves are eliminated i.e. no buffer remains to offset any unforeseen adverse developments. This forecast is still above the official target of 2.2% of GDP as a number of announced measures are not yet sufficiently substantiated, e.g. some expenditure cuts related to the budgetary chapters.

CSR 2: Adopt and implement regulations specifying the operational aspects of the new constitutional fiscal governance framework, including, inter alia, the numerical rules that will be implemented at the central and local level until the debt ratio has declined to below 50 % of GDP. Regarding the fiscal framework, implement and strengthen multiannual fiscal planning, improve the transparency of public finances and broaden the remit of the Fiscal Council. || New regulations have been adopted related to the operationalisation aspects of the new constitutional fiscal governance framework but some weaknesses pertaining to its design features can be identified. The medium-term budgetary planning is still indicative in the new framework. The analytical remit and the necessary resources of the Fiscal Council are not commensurate to its newly granted strong veto power. Finally, the availability of budgetary information is still not sufficient.

CSR 3: Enhance participation in the labour market by alleviating the impact of the tax reform on low earners in a budget-neutral manner. Strengthen measures to encourage women's participation in the labour market by expanding childcare and pre-school facilities. || The policy responses have only been partially relevant to the extent that the instruments chosen to address the impact of the tax reform on low earners have been suboptimal, while the measures to strengthen women's participation in the labour market are too limited, thus constitute a very small step in the right direction. The policy instruments cannot be considered ambitious since their scope is rather limited in comparison to the challenge.

CSR 4: Take steps to strengthen the capacity of the Public Employment Service and other providers to increase the quality and effectiveness of training, job search assistance and individualised services. Reinforce active labour market measures delivering positive evidence-based results. In consultation with stakeholders, introduce tailor-made programmes, for the low-skilled and other particularly disadvantaged groups. || There has been no progress towards meeting the recommendation regarding the Public Employment Service. Some of the measures aiming to provide tailor-made services for disadvantaged groups are relevant (the ESF programmes), others are ambitious insofar as the activation of some disadvantaged groups is concerned, but unlikely to be effective in improving the placement of participants in the open job market (public works). In the absence of a comprehensive evaluation of ALMP provision, there has not been much progress in linking funding to results.

CSR 5: Improve the business environment by implementing all the measures envisaged for regulatory reform and lowering administrative burdens in the national reform programme; assess the effectiveness of current SME support policies and adjust public programmes in order to improve access to non-bank funding. || In general, apart from the tax area, the envisaged measures are relevant and go in the right direction. The very comprehensive public consultation procedure prior adopting the program also reflects good practice. Progress towards meeting this part of the fifth 2011 CSR, therefore, has been encouraging although not uniformly so, but the size of the challenge and the high ambition of the plans point towards a need for further close monitoring of the implementation in view of the envisaged impact. Efforts to improve access to non-bank funding have been relevant, but they lack in ambition compared to the current scope of the problem, in the context of contracting credit to the corporate sector.

Europe 2020 (national targets and progress)

Employment rate target (in %): 75% || Employment rate (%): 60.5% (2009), 60.4% (2010), 60.7% (2011). The 2011 Convergence Programme calculated with the creation of 400,000 new jobs for 2011-2015. As can be seen from the latest data for 2011, there has only been a slight increase. The effect of the public works programme is already reflected in the 2011 employment data and will be responsible for most of the expected employment growth in 2012-2013. However, it would be desirable to focus on policies that facilitate reaching the employment rate by organic job creation in the market. Reasonable progress has been made towards the achievement of this objective.

R&D target (in %): 1.8% || Gross domestic expenditure on R&D (in % of GDP): 1.17%% (in 2009), 1.16% (2010 provisional figure).Hungary has recently changed the regulation of the private sector`s innovation obligations and access to funds. The compulsory innovation contribution (a percentage of their net revenues that enterprises pay to the so called Research, Technology and Innovation Fund) was abolished and the tender system for using the funds from this innovation contribution fund is under renewal. Parallel to this, the state contribution to the innovation fund will be decreased by 0.1% of GDP in 2013 according to the new NRP. The effectiveness of these schemes is currently under review. Some progress has been made towards achieving this objective, the results are inconclusive.

CO2 emission reduction target (development in %) of the Member State: -10% || Greenhouse gas emissions, base year 1990.Index 1990 = 100: 69 (in 2009) After 1990 a strong increase appeared in the CO2 emission that was due to increased public transport activity. Since 2003, CO2 emissions in Hungary follow a declining path although this decrease is slow. Some progress has been made towards achieving the objective

Renewable energy target: 14.65% in overall final energy consumption || Share of renewable energy in gross final energy consumption: 7.3% (2009). Over the last decade, the share of renewable energy in all energy usage doubled in Hungary (it was 3.3 in 1999). However, it still does not reach the average of the Member States. Some progress has been made towards achieving this objective, but there is a great deal of room left for progress.

Energy efficiency: Reduction in primary energy consumption by 2020 (in Mtoe) 2.96Mtoe || Gross inland consumption of energy divided by GDP (kilogramme of oil equivalent per 1 000 euros): 414.2 (2009), 419.5 (2010)The energy efficiency objectives are set according to national circumstances and national formulations. As the methodology to express the 2020 energy consumption impact of these objectives in the same format was agreed only recently, the Commission is not yet able to present this overview.

Early school leaving target (in %): 10% || Early leavers from education and training (percentage of the population aged 18-24 with at most lower secondary education and not in further education or training): 11.2% in 2009 and 10.5% in 2010. After the modest decrease from 2009 to 2010 (2011 data is not available yet) the mandatory school age will be changed. From the next academic year, the upper age limit for compulsory schooling will be decreased from 18 years to 16, allowing students to leave school earlier. This is not aligned with the stage at which secondary school qualifications are received and it may increase the rate of early school leaving.

Tertiary education target (in %): 30.3% || Tertiary educational attainment (% of population 30-34 having successfully completed tertiary education): 25.1% in 2009 and 26% in 2010. Hungary has made considerable progress in this area since 2006: each year on average over percentage point growth was achieved, but the Hungarian figure is still below the EU average. In the academic year starting in September 2012, the implementation of the new higher education bill will start. It is already noticeable that partly because of the significant cut in the number of fully state-funded places the number of registrations suffered a major setback by 30 000. At the same time, the full implementation is a longer process, so it is too early to evaluate. Progress has been made towards achieving this objective, albeit recent changes could slow down the improvement.

Target for the reduction of the population at risk of poverty or social exclusion: 450,000 || The number of Hungarian citizens at risk of poverty or social exclusion was 2,924,000 in 2009 and 2,948,000 in 2010. Despite the common endeavour and probably as the result of the crisis, poverty has not declined, it even grew. No progress has been made towards achieving this objective.

              5.       Annex

Table I. Macroeconomic indicators

Table II. Comparison
of macroeconomic developments and forecasts

Table III.
Composition of the budgetary adjustment

Table IV. Debt
dynamics

Table V. Sustainability
indicators

Figure. Medium-term
debt projection

Table VI. Taxation

Table VII. Financial market indicators

Table VIII. Labour market and social indicators

Table VIII. Labour market and social indicators
(continued)

Table IX. Product market performance and policy indicators

Table X. Indicators on green growth

[1]               For a more detailed analysis
on the external balances and inflation trends, please see the Hungarian chapter
of the Commission's Convergence Report released as part of the European
Semester package.

[2]               Marketingcentrum (2010) Roma társadalom

[3]               Cyclically adjusted balance net of one-off and temporary
measures, recalculated by the Commission services on the basis of the
information provided in the programme, using the commonly agreed methodology.

[4]               It may be worth recalling that, according to the
(recalculated) structural balance incorporated in the 2011 convergence
programme, the MTO would have not been achieved in the programme period.

[5]           The 2012
convergence programme includes a calculation suggesting that the 2011 general
government deficit excluding one-off items within the year was only 2.43% of
GDP. This figure, however, does incorporate an important part of the one-off
revenues (i.e. the budgeted part of the revenues stemming from the transfer of
the private pension assets and the entire amount of the temporary sectoral
levies).

[6]               The government finally took over only HUF 50 bn
(close to 0.2% of GDP) of the railway company’s debt (MAV), which cannot be
accounted for as one-off expenditure mainly since it was needed to cover the
annual financing gap  of the MAV.

[7]               These additional one-off expenditures include VAT
related compensation payments in the light of the EU Court of Justice’s
decision of July 2011, the public expenditure pertaining to the early FX
repayment scheme and a part of the capital injection in the Hungarian
Development Bank.

[8]               Regarding 2012, the 2011 convergence programme
contained saving measures of slightly more than 1½% of GDP, mainly related to
the Szell Kalman structural reform programme (such as the reduction of
unemployment benefit and pharmaceutical subsidies).

[9]               An extraordinary reserve of 1.1% of GDP was
incorporated in the 2012 budget, which was complemented by close to 0.4% of GDP
thanks to saving measures announced in the 2012 convergence programme.

[10]             This no-policy-change scenario already incorporates of
the deficit-improving effect of the further implementation of the Szell Kalman
structural reform programme of around ½% of GDP, which, however, is partly
offset by increasing expenditures (e.g. further extension of the public work
programme) and revenue reducing decisions (e.g. narrowing of the tax base for 
personal income tax).

[11]             As regards the financial transaction duty, the 2012 convergence
programme envisages a revenue of 0.4 – 0.75% of GDP.

[12]             The reserve is expected to be between 0.2 and 0.5% of
GDP depending on revenue raised from the financial transaction duty.

[13]             New information clarified the extent to which the
budgets of the various ministries and the appropriations are affected and indicated
that the intended savings are based on the cancellation of selected tasks and
efficiency improvements, which can ensure their sustainability.

[14]    The Economic Stability Law also stipulates that the income tax
system is proportionate and the family tax allowances cannot decrease. These
unusual provisions, which require a2/3 majority in Parliament to be amended,
significantly limit the ability of the current or any future governments to
change the tax system and adapt it to budgetary requirements.

[15] See e.g. Elek et al (2009) A bérekhez kapcsolódó adóeltitkolás
Magyarországon

[16] World Economic Forum (2011-12) Global Competitiveness Report

[17] See e.g. János Köllő (2011) Kudarcismétlő szakoktatás

[18]             The 2012 FRA/UNDP/WB report ‘The Situation of Roma in
11 EU Member States’ states that the percentage of households at risk of
poverty is much higher – more than double – for marginalised Roma households
than for marginalised non-Roma households.

[19]             Discrepancies can be observed in the fields of
education, employment and the accessibility of social services. In addition, the
foreseen transfer of schools with a Roma majority to Roma self-governments
increases the risk of school segregation.

[20]     Report of the State Audit Office of Hungary on the Budapest
Transport Company, January 2012 (http://www.asz.hu/jelentes/1202/jelentes-a-budapesti-kozlekedesi-zrt-gazdalkodasanak-ellenorzeserol/1202j000.pdf)

[21]             E.g.
only about ¾ of railway passengers need to buy a ticket at all (http://www.mav.hu/res/MAV\_CSR\_jelentes\_2009.pdf)

[22]             Based on European Commission DG ENV (2011) Implementing
EU Waste Legislation for Green Growth.

[23]             World Economic Forum (2011-12) Global Competitiveness
Report.

[24]             According to the Government Decree (1133/2011) on the
first steps of administrative burden reduction adopted in May 2011 a first
evaluation should have been prepared six months after the adoption of the
Decree.

[25]             See also Reszkető Petra (2012) Vállalkozni kicsiben és
nagyban –Magyarország (Budapest Institute).

[26]             CEPEJ (European Commission for the Efficiency of Justice),
2010 Report,:

http://www.coe.int/t/dghl/cooperation/cepej/evaluation/default\_EN.asp?.

[27]             Transparency International (2012) Corruption Risks in
Hungary 2011.

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