-16-

For Hungary, table 4 below shows nominal and real interest rates as well as effective tax rates, using equation (2), between 1988 and 1995.19 Trends in effective tax rates for Hungary are erratic. Real interest rates were negative between 1988 and 1993 (except for 1992). Taxing nominal interest payments resulted in a worsening of disincentives to save. In 1994, savers were able to earn positive real interest for the first time. As shown in table 4, the effective tax rate on interest income amounted to 50% -- compared to a nominal tax rate of 10% ! After abolishing the tax on interest payments in November 1994, the effective tax rate fell to zero.

**Table 4: Hungary: Inflation, Interest Rates, and Effective Tax Rates, 1988 - 1995**

||1988|1989|1990|1991|1992|1993|1994|1995|
|---|---|---|---|---|---|---|---|---|
|Inflation (in percent, CPI)|15.8|16.9|29.0|34.2|22.9|22.5|18.9|28.3|
|Nominal interest rate 1|9.0|15.0|27.4|32.5|23.6|16.5|23.6|29.1|
|Real interest rate<sup>2</sup>|- 5.9|- 1.7|- 1.2|- 1.3|_0.5_|- 4.9|4.0|0.6|
|Effective tax rate on interest<sup>3</sup>|- 26.5|- 149.5|- 349.0|- 363.8|784.3|- 54.8|49.9|0.0|

I Unweighted average of interest rates on treasury bills and deposits.

2 The relation between nominal and real interest rate r is given by I + R = (I + r) * (I + p) . For small r * p , the expression can be reduced to R = r + p for simplicity.

3 Negative signs do not indicate negative effective tax rates (i.e. a subsidy). Rather, they are explained by a negative denominator in (2), which implies a negative tax base but, nevertheless, positive tax payments.

Sources: IMF International Financial Statistics; and own calculations.

As highlighted by the data in table 4, inflation distorts saving by discriminating against assets that are not inflation-proof. Tax policy, in principle, should acknowledge this problem by taxing real rather than nominal returns. Such attempts have rarely been undertaken in the past, mainly because systematic adjustments appear to be difficult and, hence, expensive (Sorensen, 1994, p. 63). Another attempt to account for inflation in the design of the tax system would be to apply reduced 20 tax rates on interest as compared to other types of capital income. However, this seems to be an inferior solution because the non-distorting tax differential depends on the actual inflation rate and would, accordingly, be subject to permanent change. In particular, moderate-to-high inflation economies like Hungary would face the need for constant adjustment.

Even though official statements mentioned that revenue considerations rather than ,,effective tax rate" considerations were the driving force behind the reform, and even though the tax reduction

**19** In principle, effective tax rates should be calculated using _expected_ inflation rates. Lacking better data, we used expost outcomes instead. This is justified in case of perfect foresight of savers, or when inflation forecasts by public institutions and actual outcomes coincide.

20 Muten, 1996, p. 12, mentions that, in 1994, Swedish authorities chose a tax rate of 30% on capital income for this very reason. Under reasonable assumptions on interest rates and inflation, the resulting effective tax rate of about 50% corresponds to the highest marginal PIT rate.