The large inactive population, high and badly structured state redistribution, corruption, possible ethnic tensions and the emergence of the far-right are the key risk factors that could hinder economic recovery in Hungary.
I. Large inactive population
Hungary’s relatively low number of active workers dramatically undermines its long-term growth potential. The percentage of citizens who actively contribute to the economy is the lowest in the region and the second lowest in the EU -- 61.5% in 2007, almost ten percent lower than the EU average of 71%.
At the beginning of Hungary’s transition to a market economy, politicians deliberately encouraged inactivity as a means of reducing unemployment. This was achieved by loosening regulations on who qualified for early retirement or disability pensions. As a result, 11% of Hungarians are now living off disability benefits, the highest rate in the EU. Rising unemployment (currently 10.1 percent) exacerbates this problem.
This high rate of inactivity stems from a deficient interaction between weak human resource capacities on the supply side (catastrophic demographic trends, bad healthcare indicators and a low motivation to work) and a system of poorly designed bureaucratic incentives that reduce the demand for workforce.
Instead of stimulating employment, the state prefers to incentivize absenteeism from the national economy with high social spending. Despite some reductions in the last years, the social benefits remain too generous and serve to discourage a broad group of potential employees from returning to the labour market. According to a 2008 survey by the government’s Office for Employment and Social Policy, 20% of the citizens living on the dole said they were completely satisfied with their standard of living and were unwilling to return to work. The rate of inactive citizens receiving regular social payments has increased 77 percent since the beginning of the decade. Therefore, inactivity is diminishing the country’s growth potential both directly (by causing workforce supply-and-demand problems) and indirectly (by placing an enormous burden on the central budget).
The government, especially under Prime Minister Gordon Bajnai, has recently begun implementing stricter policies on early retirement and disability, as well as cutting social benefits and maternity-leave subsidies. However, further measures are needed to curb economic inactivity, which has risen over the past two years. These steps are certain to be politically unpopular.
II. High and badly structured state redistribution
High rates of economic inactivity and workforce difficulties are related to another key problem: high taxes on labour. This reduces demand for workers and hinders long-term economic growth. Hungary’s tax system is not only onerous, it’s also extremely complicated, which encourages tax evasion and avoidance. Between a quarter and a third of Hungary’s GDP disappears from the tax base because of tax dodging, according to NBH estimates. 
Hungary has fallen significantly behind its regional competitors in the past few years. This can be partly explained by its high tax burden and its overly generous welfare state. Despite a slight decline in 2009-2010, state redistribution in Hungary remains the highest in the region. Hungary cannot realistically maintain its highly centralized system of wealth redistribution because neighbouring countries are forcing it into an intense “tax race.” Most regional countries have recently reformed their tax systems and reduced expenditures significantly; Hungary is lagging behind. As a result, most of Hungary’s neighbours were witnessing dynamic economic growth until the economic crisis struck. Hungary was not.
In 2009 the government took some steps toward reducing central redistribution. This process will accelerate in 2010. Still, the next government will not be able to avoid taking further measures to improve Hungary’s long-term economic prospects. The areas that are most in need of reform are the tax system, the welfare system, the public transport system, the state bureaucracy (especially the extensive and expensive municipality system), education and healthcare. The main opposition party, Fidesz, has a broad support base that gives it a reasonable chance of successfully implementing reforms. (Some reform-policy plans are already circulating within the party and its associated groups). Fidesz has stressed the need for tax reform for so long and with such vigor that an overhaul of the fiscal system is one promise it simply won’t be able to avoid keeping. However, additional reforms will be then needed to counterbalance the ensuing reduction of state revenues. And there are several factors that cast doubt on Fidesz’s appetite for reform in certain policy areas:
- Past Experience. Fidesz, which was in power between 1998 and 2002, tried to avoid extensive reforms that could have induced intense and long-term social/political conflicts.
- Fidesz’s own camp. Fidesz’s anti-reform agenda of the past few years may come back to haunt it in 2010, when the party is expected to win an absolute majority in parliament. For example, Fidesz initiated a 2008 referendum that rolled back reforms in healthcare and education. In the coming years, such policies may narrow its room to maneuver, because any reform steps may meet with strong resistance from party members, the right-wing media and voters.
- Civil resistance. Civil society players (e.g. labour and professional chambers) are generally weak, but they are able to block the reforms when they cooperate with opposition parties. In the past few years, “reform” has become a synonym for “chaos” in the public eye. Fears of structural change are easily activated among the public.
- Fidesz’s political opponents. The Hungarian Socialist Party (MSZP) and especially the ultranationalist Jobbik party can criticize Fidesz’s every move in hopes of destroying the party’s credibility. Once in government, Fidesz members expect to have broad room to maneuver because they will lack serious political rivals. But political confidence in Hungary is extremely fragile; any sign of waning popularity may discourage Fidesz members and prompt them to put off the reforms.
An estimated 1 trillion HUF (3.25 billion EUR) disappears down illicit channels in Hungary every year. Corruption is not just a problem for the public sector, where 400 billion HUF (1.5 billion EUR) vanishes every year, but for the private sector, where approximately 600 billion HUF (2.25 billion EUR) “evaporates.” Corruption raises prices by an estimated 25%, while some 65%-75% of business and government tenders are tainted. High corruption institutionalizes unofficial political influence on the business sector. Legislative shortcomings, such as the extremely opaque party- and campaign-finance system, exacerbate the problem because political players raise much of their funding through illegal practices. One particularly widespread abuse is the so-called “corporate tender reimbursement” system, where government bodies purchase services from private companies at deliberately high prices, then demand some of the funds back under the table. The perceived high level of political corruption is one of the principal reasons for public mistrust toward politics and the democratic system.
Societal tolerance of bribery helps maintain the high level of corruption. Everyday corrupt practices (such as giving “gratitude money” to public doctors, bribing a police officer or paying off ticket checkers on public transport) means people are preconditioned to put up with more serious violations. In a sense, public opinion supports corrupt practices: Although the majority of Hungarians condemn “active” bribery, they consider corruption to be a natural part of political and business life alike, according to opinion surveys. Thus “passive” corruption, such as taking kickbacks, does not inspire outrage in the public at large. This can serve to justify loose ethical standards toward financial malfeasance among Hungary’s citizenry: “Everybody does it, why shouldn’t I?”
Tolerance of corruption in different countries:
Aggregated index, source: Tárki Institute, World Value Survey, European Social Survey
When taken together, the above problems form a “vicious circle” that poses a huge dilemma for economic growth. Hungary needs high taxes to support social spending and to pay benefits to its inactive citizens. This makes it necessary to have a high level of centralized redistribution and an extensive bureaucracy. This, in turn, fuels rampant corruption – and corruption, or at least its perception, undermines citizens’ willingness to pay taxes: They are reluctant put their money in a “leaky bag”. And loose tax morals make politicians hesitant to cut tax rates -- thus closing the circle.
IV. Ethnic tensions and the emergence of the far-right
As the previous two points demonstrate, societal factors can pose grave risks for economic productivity. Hungary’s social context may make it difficult for the nation to maintain economic progress.
Since 2006, the issue of Hungary’s Roma (Gypsy) minority has risen to the fore of the political agenda after years of simmering beneath the surface. The Roma issue, long ignored by politicians, has been introduced to the public arena by the right-wing Jobbik party and the Hungarian Guard, a paramilitary organization with strong ties to Jobbik. They use anti-Roma prejudice to define its political approach, unabashedly railing against “Gypsy crime” and “parasitism”. Jobbik has evolved from a right-wing student group into a political force with stable nationwide support: It garnered more than 427,000 votes, or 15% of Hungary’s total, in the 2009 European Parliamentary elections.
Recent efforts to halt the spread of extremism have failed. Support for Jobbik is trending upwards, while its recruiting tool, the Hungarian Guard, continues to operate in spite of a court order banning the group. Ethnic tensions are expected to rise ahead of the 2010 vote, as political campaigns focus on anti-Roma sentiment and the economic crisis. It’s possible that other political groups will play with anti-Gypsy prejudice, which is a feature of more than two-third of society. The economic crisis has further increased poverty in the Roma community, aggravated social differences, and reinforced dissatisfaction with the entire political system. This increases the far right’s scope for action.
Ethnic tensions and the surge of the far right pose the following risks for economic recovery:
- The high rate of economic inactivity in the Roma population represents a threat to both the workforce and the social insurance system. Many Gypsies found it difficult to adjust to market competition following the regime change in 1990, partly because of segregationist practices in certain areas and the Roma population's chronic educational and cultural deficit. High unemployment means a large number of Roma live in severe poverty; social subsidies for Gypsies represent a huge burden for both municipal and national governments. Since Roma birth rates are typically higher than in the population at large, the size of the Roma minority (currently about 7% of the total population) will grow significantly in the coming decades. The problems will deepen if no effective policy responses are taken now.
- As indicated in our Risk Warning on the Hungarian Guard in December 2007, the rising activism of the far right seriously damages Hungary’s international standing. On top of this, the increasingly open verbal and physical atrocities against Gypsies may lead to the radicalization of the Roma population. The formation of Roma self-defence groups may increase the risk of violent ethnic conflict. The only time Hungary made it to the front page of western newspapers last year was with stories about either the economic crisis or ethnic tensions brought on by the rise of the far right. Journalists tended to treat the latter as a side effect of the former. Any worsening of the conflict may damage the country’s image just when confidence in the Hungarian economy is starting to revive, undermining Hungary’s ability to attract foreign investment in the long term.
- The emergence of the far right can push political players towards more radical stances. This brings additional risk. Rising nationalism, anti-Semitism and verbal attacks on “alien capital” not only threaten investors, but can also influence anti-investor decisions in both the national and municipal governments. For example, a scandal erupted earlier this year when the government entered into a real estate transaction with an Israeli investor who wanted to build a casino in the resort town of Sukoró. The right-wing media linked the transaction to the investor’s ethno-religious background, thus satisfying the need for political anti-Semitism. In the future, not only will investors become more cautious, but decision-makers may also be afraid of letting in companies from certain foreign countries for fear of scandals. Two recent controversies in particular may give investors pause: The “Suez affair,” where the Pécs city government broke its contract with a French water-supply company and seized control of the municipal water works; and the “frequency affair,” where state broadcasting regulators forced two foreign-owned radio stations off the air and awarded their frequencies to two Hungarian media companies -- one has close ties to Fidesz and the other is chummy with the Socialist Party. Investors will doubtless be watching economic policy developments with increased vigilance.
 For more on the reasons and consequences of Hungary’s high unemployment rate, see the following study by the National Bank of Hungary: http://www.mnb.hu/Engine.aspx?page=mnbhu_mnbtanulmanyok&ContentID=12488
 Tax evasion and tax changes in Hungary
 Source: GKI Economic Research Co.
 Political Risk in Hungary has increased due to actions of the Hungarian Guard http://www.riskandforecast.com/post/hungary/political-risk-in-hungary-has-increased-due-to-actions-of-the-hungarian-guard-_51.html
The Suez affair in Hungary: Fidesz and the foreign investors