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Bulgaria and Albania joined Russia, Slovakia, Romania and nine other Central and Eastern European countries by adopting a flat tax system at the beginning of the year. Four of Hungary’s seven neighbours have already chosen the flat tax option. In fact, flat tax is now the preferred system among the post-communist economies of Central and Eastern Europe. Is Hungary – already suffering the lowest rate of economic growth of the new EU member states – in danger of being left behind?

With Bulgaria and Albania going for 10% across the board, will Hungary join the flat tax club?

At the beginning of the year, Bulgaria and Albania joined Russia, Slovakia, Romania and seven other Central and Eastern European countries in adopting a flat tax system. Four of Hungary’s seven neighbours have already chosen the flat tax option. In fact, flat tax is now the preferred system among the post-communist economies of Central and Eastern Europe. Is Hungary – already suffering the lowest rate of economic growth of the new EU member states – in danger of being left behind?

Bargain basement Balkans

On 1 January this year, EU newcomer Bulgaria introduced a flat tax rate of 10% for both income tax and corporate tax. However high a Bulgarian’s salary, and no matter how large a company’s profit, the Bulgarian state now only demands 10% of it.

To western Europeans, this may sound like the utopian stunt of a madman, but in fact flat tax policies – until recently little more than a theoretical notion dreamt up by economists – have rapidly caught on in the developing economies of central and Eastern Europe since Estonia opted for the novel system in 1994.

Shortly after Bulgaria’s intentions became clear, regional economic minnow Albania announced it was joining the fray. Since 1 January that mountainous backwater has also adopted a rate of 10% across the board.

What is it?

A flat tax system is an alternative to the progressive taxation systems that have evolved throughout most of the developed world. With a flat rate of tax, regardless of how much a person earns, he pays the same proportion of his wage to the state. With progressive tax, a pay rise can lead to an increase in the percentage claimed by the government.

In a “pure” flat tax system – such as that in Slovakia and now Bulgaria and Albania – income tax (as paid by the employer and the employee), corporate tax and VAT are all set at the same level. In practice, some states have been a little more flexible. Income tax is generally a one size fits all affair, but with intra-regional competition for foreign investment hotting up, several states have opted to lower their rate of corporate tax.

Pros and Cons

If flat tax is such a good idea, why is nobody else – apart from a handful of places like Guernsey, Hong Kong and Mauritius – using it? The answer seems to lie in the level of development that economies have achieved. Western European states, for example, have evolved a system based on the principle that high wage earners pay exponentially more tax, while the low paid often pay no income tax. One of the main criticisms of flat tax systems it is that they are unfair on the poor.

The trouble faced by all post-communist states is that they inherited a flourishing black market and a rigid mindset among the population that the state exists to run things, not to take money. If you impose a Scandinavian-style tax system on such countries, without the benefit of a well-resourced and effective tax collection system, people simply refuse to pay.

The governments of all the countries highlighted in the map on page 1 have made the pragmatic decision that a simple, low-rate tax which is easy to collect and difficult to evade is likely to raise more money than a high-rate tax system that is full of loopholes and which nobody fully understands.

Hungary, as a Hungarian financial consultant once jokingly said, aspires to Scandinavian levels of taxation but tries to collect it through eastern European institutions. That may be an overstatement, but the fact is that despite a piecemeal government crackdown, Hungary’s black economy is still estimated to account for some 20% of national GDP. Prime Minister Ferenc Gyurcsány once called the country “a nation of minimum wage earners”, in reference to the widespread trick of claiming the minimum wage on paper and taking the bulk of earnings cash-in-hand or in kind.

Corporate tax

As mentioned above, a separate battle is taking place in the region – the battle to attract Foreign Direct Investment (FDI). To attract companies looking to invest in a region that offers cheap and often well educated workers, governments have been slashing their rates of corporate tax.

In 2001, Serbia – which already had a flat tax rate of 14% – cut its corporate tax rate to 10%. Albania’s new flat tax policy means its corporate tax fell from 20% to 10% as the new year was rung in. The Bosnian Federation’s cut was even more drastic: from 30% to 10%. With its massive and largely untapped economic potential, Russia is not far behind, with corporate tax at 13%.

Hungary

Corporate tax is one factor that companies weigh up when choosing where to locate, but the main complaint of the business community in Hungary is that the cost of employing staff is among the highest in the region – and not because employees demand higher take home pay. With payroll taxes eating into profits, the level of corporate tax – 16% in theory, but see below – is less of an issue.

Compare Hungary with Slovakia. Hungary’s northern neighbour has opted for the purest of flat tax systems. Employers’ and employees’ income tax contributions are fixed at 19%, as is corporate tax and even VAT. Thousands of Hungarian companies have already relocated their headquarters to Hungarian-speaking southern Slovakia – not only are taxes lower, but accounting has been made child’s play.

Hungarian employers must pay 16% income tax and 29% social security on payroll, while employees pay between 18% and 36% income tax plus a host of social and other contributions. The net result of this is that the government receives up to double what the employee takes home. Corporate tax is 16% – although an additional “solidarity tax” of 4% must also be paid on company profits, boosting the de facto rate to 20%. Solidarity tax is also payable on salaries of over HUF 6 million (EUR 23,280). On top of that there is the local business tax – seen as a turnover tax in all but name, despite a recent EU ruling to the contrary – which can cost companies up to 2% of revenue regardless of whether they make a profit.

Not only might Hungary’s high tax burden make potential investors view its flat tax neighbours more favourably, but businesses already located here have been grumbling that the country’s expensive and over-complicated system could drive them away. The vice president of Hungary’s largest foreign investor General Electric, which has invested over USD 1 billion in the country to date is scathing about the solidarity tax. In an interview with financial daily Napi Gazdaság last December, John G. Rice warned that his company would consider shelving plans for further investment if a satisfactory deal cannot be reached with the government.

No levelling for Hungary

The small, conservative opposition party the Hungarian Democratic Forum has long been calling for the adoption of a flat tax model. Party leader Ibolya Dávid argued last year, when the Czech Republic chose to follow its southern neighbour Slovakia into the flat tax world, that Hungary risks losing out in the battle for foreign investment and lagging behind if it does not follow suit.

The Hungarian government, a coalition of the Hungarian Socialist Party (MSZP) and the Alliance of Free Democrats (SZDSZ) is currently mulling over reforms to the tax system.

Finance Minister János Veres said last week that any tax cuts made would add up to no more than HUF 200-205 billion (EUR 777-797 million). One suggested model proposes lowering employers’ national insurance payroll contribution from 29% to around 21%, while raising VAT from 20% to 22-24% to compensate. Financial news portal portfolio.hu suggested that a three-bracket income tax model was under discussion, with rate of 16%, 32% and a new level of 44% for those earning over HUF 8 million (EUR 31,115) per year.

Earlier this year, it was reported that two of four possible alternatives included the adoption of a flat tax model. However, last week Magyar Hírlap reported that the cabinet working group had ruled out any such move.

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