On 1 January 1988 Hungary introduced a Value Added Tax and a Personal Income Tax as key elements in its transformation from a bureaucratic socialist to a decentralized market economy, which were followed on 1 January 1989 by an Enterprise Profits Tax. This application of a tax system based on law to all individuals and enterprises formed a central element in Hungary's replacement of bilateral bargaining with a decentralized system in which private agents can plan with expectations of a reasonably stable economic environment.

In Discussion Paper No. 558, Research Fellow David Newbery notes that pre-tax income differentials will widen as enterprises set wages in line with marginal productivities and lay off workers, and as entrepreneurs and speculators find profitable opportunities. Hungary has highly egalitarian pre- and after-tax income distributions, and its tax and transfer system appears to do an excellent job of protecting the vulnerable. Hungary has clearly sacrificed efficiency for equity to an extent hard to reconcile with a market economy, so the move to greater competition and incentives will clearly increase the inequality of its after-tax income distribution.

If Hungary had realistic prospects of rapid growth, the poor might gain despite growing income differentials, but the size of the external debt and the terms-of-trade shock implied by the collapse of intra-CMEA trade make such growth unlikely, while the structural adjustment now required will impose further strains on income distribution. The effects of such adjustment on poverty will largely depend on the government's initial objectives and the political constraints it faces. The Hungarian government has been at least as egalitarian as any elsewhere and its redistributive system ensured a remarkably low level of poverty relative to its overall income level. Adjustment therefore requires that its egalitarian policies be scaled back: if reform is to unleash the repressed forces for greater efficiency and increased income, the tax and reward system must become less progressive, which will harm those at the lower end of the income distribution.

Newbery notes that the gains from reform will not arrive in the early part of the transition. Since domestic consumption will increase only slightly for the first few years, those who gain will do so at the expense of others, probably the more vulnerable. The key political issue is whether the latter will be protected during the transition with the brunt of the burden borne by the middle income deciles or whether the middle income deciles will be protected at the expense of the extremes. Since much of the current transfer system is mediated through enterprises and local authorities, it will almost certainly face restructuring in the near future; and the government faces a major challenge in seeking to preserve the better features of the existing system while economizing on its less well-targeted elements.

An Analysis of the Hungarian Tax Reform
David M Newbery

Discussion Paper No. 558, May 1991 (AM)