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The empirical evidence is mixed. A direct linkage between a reduction in tax rates and an increase in savings cannot be established in general, as it depends on the choice of the underlying model (see Burgess/Stem, 1993, 796). As stated in a recent OECD study, ,,there is no consensus over whether a higher rate of return to saving increases saving in the aggregate or reduces it" (OECD, 1994, 42). However, while taxation might not affect the _level_ of savings, it certainly influences the _composition_ of savings. The portfolio choice of households will be distorted when the tax system treats different types of financial assets differently. Neutrality can be achieved with a uniform treatment of all assets, for example with a comprehensive income tax or a flat-rate scheme for capital income (OECD, 1994, 190). A clear tax policy implication is that the unequal treatment of capital income should be avoided. Instead tax rates varying between 0% on interest and 40% on dividends plus PIT on capital gains, the playing field for different types of capital income should be leveled as much as possible.

_48_ A reformed capital tax framnework should improve efficiency in financial markets. In Hungary, financial markets are very un-developed. The market for bonds is completely dominated by government issues. High levels of public debt are reflected in a relatively large market for government securities, which makes up 30% of GDP (1996). The contribution of corporate bonds is negligible; they are mainly issued by banks and leasing companies. The market for equity is small as well, equivalent to 7% of GDP. Strict capital controls still exist. For example, foreign investors are not allowed to hold private bonds. In addition, foreigners need to apply for a special trading license in case they wish to acquire public bonds with a tenor of less than one year or which were issued before April 1996. Due to these constraints, foreign investors only acquired 1% of government securities (T-bonds) in 1995.

How does the tax system distort incentives? First, in Hungary as in other transition economies, growth depends largely on the build-up of new enterprises. The latter generally have problems providing collateral and therefore depend on equity financing. The Hungarian tax system imposes relatively high costs on equity financing and, hence, discriminates against new enterprises. Second, by favoring debt financing of corporations, the tax system increases the risk of bankruptcy. Another distortion is due to the fact that some entities (such as pension funds under the 1993 law) enjoy preferential tax treatment.<sup>49</sup> These institutions are able to acquire company shares above the ,,appropriate" level, resulting in excessive profit distributions.

**48** Governments have a number of tools at their disposal to facilitate the development of financial markets. Most important are the extent and structure of government borrowing, regulation and de-regulation of financial markets, and the tax system (Stiglitz, 1991). If the tax system favors certain types of assets and discriminates against others, financial markets will not operate efficiently. Such distortions can entail significant economic costs (Tanzi/King, 1995).

49 Benefits received from the (voluntary) funded system created by the law of 1993 are not taxable. Capital income accruing to the fund is not taxable either, in line with the general principle of not taxing interest on savings deposits. Contributions (from workers or from employers) are taxable within the PIT but, for contributions up to HUF200,000