White mice - Updated

After months of permanent "revolution" the prime minister, Viktor Orbán announced new measures this Wednesday aimed to bring the budget deficit under the ceiling aggreed with the EU, supposedly without austerity. It would be easy to mock him how he defines austerity (as next years budget is planned with a nominal cut in budget expenditures, obviously affecting a lot of people) but I presume it will be a popular activity in the coming weeks. It is more interesting whether this new action plan (complemeted with a modified tax system due to be announced next Monday, but a series of ideas already known) signals a dicision at last concerning the economic policy. Especially as the 29 point from June were the sign of indecision. (See my post here.)

It would be easy to dismiss yesterday's plans as the postponement of this state of agony, as it is not easy to see any coherent direction of action in the rather patchy series of new - intentionally only temporary - levies. However, considering the nature and content of the earlier internal conflict and the resulting political dilemma for Orbán, this time one should assume the decision has been made and what one can see is the backbone of the new economic strategy of Hungary's government. For years economists around and inside Fidesz fought a pitched battle whether the state has to be reduced with drastic cuts in order to make room for tax cuts in a corresponding extent or taxes should be reduced without any offsetting measures. Funnily and ironically proponents of both directions pointed out the same examples, most notably Slovakia, but in the last few years Romania and Bulgaria as well. The representatives of the former line - many of whom participated in the activity of the Reform Alliance in 2008 and 2009 - argued that the size of the state was and is too large and its extent of income redistribution - especailly with its ratio of social expenditures - is crowding out private investment and depresses initiatives. A much smaller state would enable the private sector to invest more leading to higher production and with time higher income. However, according to this line of thought, the balanced budget is a precondition of higher grwoth, because the budget deficit is just as harmful as the high redistribution ratio. If the state runs deficit it needs financing and the sivereign bonds issued attract the capital easier than investment. Those holding an opposite view in Fidesz do not deny the necessity of a smaller state. Nevertheless, their recipe is quite different, as their diagonisis focuses on the reasons of the weakness of economic growth eslwhere, finding it in the lack of sufficient internal demand. Therefore they propose a kind of shock, government measures in order to raise personal income levels creating the preconditions of rapid growth.* They presume this boost of internal demand would lead to such a growth rate that would allow a larger state expenditure in nominal and real terms and simultaneously reduce the redistribution rate as a ratio of GDP.

It is clear the latter "soultion" needs either a very benevolent attitude form those financing the diefict or a permission of the EU, the guradian of the Stability and Growth Pact, because it is usually seen as a way leading to immediate worsening of the situation of the budget. Even if faster growth would bring higher revenues with time as the proponents of this solution claim (far from being certain, but a very popular argument) someone has to finance this transitional period. The idea of a higher deficit for this year, so ferociously defended (portrayed as inevitable) during the run up to the election and afterwards served exactly this purpose. After the EU Commission reppoached Orbán and made it clear they wouldn't accept any deviation from the plans outlined by the outgoing government the circle looking for this way needed to find another soultion. For a while it seemed the former group prevailed and next years' budget will be constructed very cautiously, but meanwhile there were signs of attepmts signaling the almost desperate will for implementing the second version of economic policy. Despite these signs "analysts" and "economists" were deluded by the readily repeated promises of government officials that Hungary will stick to the deficit target both this and next year. They convinced themselves it logically means bugdet cuts, asuterity, reforms.**

Yesterday it turned out we won't see the first alternative being realized, instead Orbán Viktor opted for raising internal demand without lasting measures to offset losses. It doesn't mean the budget won't be extremely tight, but every inch of room for maneuvre will serve the purpose of a huge tax cut. (The one I sketchily characterized in my previous post.) However, the whole action has a transitory nature as the government expects a new wave of additional revenues from higher growth. New windfall taxes on telecommunication companies, on the energy sector and on retail cahins will be imposed (already due this year!) and contributions to private pesnions schemes (obligatory for at about 3 million people in Hungary) will be withhold in the budget. Whether it is the first step towards complete nationalization (a very contorversial issue under EU law) or just a necessary step to cover losses temporarily (the minister hinted to an eventual compensation, although without specifying its nature) is not clear. Anyway,for many observers it seems the government bought itself enough time to bring about its tax cut without destroying the budget and placing the country at the mercy of external financers. Doubts are only raised regarding durability of the reduction of the budget deficit when these measures expire without significant reforms.

If the informations regarding the harsh cuts in the budget (affecting sectors like health care, already drained by years of austerity) turn out to be correct one should conclude the situation is more serious than one would have thought earlier. In this case it will be clear the country is the scene of a mass experiment of supply side economics and the government is playing a gamble. Not that some of the problems they conceive would not be real. Further austerity - albeit propsed by the EU and requested and expected by the markets - could easily push Hungary to the Greek, Irish or Portuguese road. Austerity depresses growth and fails to reduce debt to GDP ratio lastingly making a new wave of cuts necessary and further depressing growth. The vicious circle is not easy to escape (I tend to think it is impossible without coordinated efforts of the EU) and the governments plans to brake it can be seen as legitimate. Although some of the doubts echoed are equally legitimate, the real problem with the proposed solution lies elsewhere. The government relies on the assumption that the only hindrance for growth in the country is the depressed internal demand and a sufficiently strong boost will give the necessary impulse to the economy, bringing new orders to local SMEs etc. In order to achieve this they will introduce a Slovak-type tax system (they even copied the abolishment of the inheritance tax) accompanied by Slovak-type social assistance system, but contrary to the Slovak model they won't prefer market-oriented reforms of systems like the health care, child benefits or pensions. A very strange version of neoliberalism (provincial and protectionist) but still supply sider neoliberalism.

This is exactly the Achiles heel of the whole plan, it focuses on one single factor and assumes a large enough change will generate substantial changes in the whole economy and society. Ironically, it would need a completely and perfectly funcitiong economy, something doesn't exist in the country to the extent the plan would presume (and the existence of which would make the whole idea obsolete). But beyond rather insignificant general observations the whole plan suffers from many important deficiencies. Firstly, there is no sign of the rowth generating effect of stronger internal demand among the present circumstances. Real wages and incomes have grwon in Hungary in this year due to not insignificant tax cuts for middle income categories. On some income levels it was almost 10% raise of net income and on an aggregate level in the first half of the year real income was 5% higher than a year earlier. (This is now fading due to base effects.) Nevertheless, retal sale were continously decreasing, an omnious sign for every attempt to use internal demand as a means of stimulus.***

An even more important factor giving way to doubts is the very uneven distribution of benefits from the proposed tax cuts either in terms of social status or georgraphy. According to preliminary calculations based on the leaked informations on the new tax system a very sognificant part of the working populatioin will not be better off or only with an insignificant ammount, probably meaning a loss of real income. It won't be offset by the child allowance fr these social groups. Moreover, even families with low income but three or more children will not benefit from the generous child allowance. The only group that will certainly enjoy a significant advance in financial terms will be the one of families with high income and three or more children, while the more people earn at the present the more positive the effects of the tax cut will be. Although it is hard to assess the distribution of the tax cuts precisely, it is safe to assume it will make better the position of those with a lower marginal propensity to consume except families with children. Moreover, while the tax cuts can serve as a stimulus via internal demand, the cuts of budget expenditure will have a negative effect on public invesment and public consumption, a factor of GDP dragging down growth already for years. Once again, I have no clue to the ratio of these conflicting effects, but it is hard to accept the planned 500-600 billion HUf tax cuts will raise grwoth with the envisaged 2%.

Of course one can say at least the demographic effect will be positive and I wouldn't be surprised to learn of a temporary positive change in the birth rate in next year. Given the number of live births just under 100000 per year 10000 additional newborn would be a very significant development. However, as I mentioned the child allowance will only mean a significant help for thosew with extremely high income (by Hungarian standards) and with three or more children. People with high income could opt for a third child, but it still won't change the picture fundamentally. Meanwhile the sate will renounce on the social infrastructure of child upbringing (kindergartens, play-scholls etc.) as it won't have the necessary funds to rebuild the instiutions lost in the last two decades. The well-to-do large families will be able to afford private kindergarten (the monthly fee of which is equal to the ammount of the entire child allowance planned!) and will be able to finance one of the parents remaining at home, while those with less children and/or lower income will still struggle to reconcile work (substantial to secure an accepatble family income) and child care. The whole complex is aggravated by the fact that in the backward regions of the country where unemployment - longterm, structural - is concentrated and where the above mentioned larger family type with low income (somteimes living on social assitance) is widespread people's burden won't really be lifted by this new tay system. The result: higher inequalities in the country, less opportunity for people in these reagions and less social mobility. The latter is especially important as under the planned tay system lasting positive developments in demography would need very strong social mobility, because the real positive effect on birth steps in at higher income levels. As long as one can not break away from poverty or the trap of mediocre income one could not really enjoy generous child allowance. (The difference is huge. The child allowance is worth 10000 HUF for the first two children each, and 33000 for each children after the third one is born!)

(Some additional thoughts.) The last - but not the slightest of problems - of the new line of action is that ironically it makes Hungary even more dependent on external factors than earlier. While the government claims to have realized economic independence with getting rid of the IMF, its plan is based on the positive development of a series of external factors. Even if one assumes a turnaround in the reatil sales (a signal of grwoing internal demand) public consumption and investment will affect GDP negatively. Therefore, Hungary will need significant export growth to make its very ambitious plans a reality and collect the revenues envisioned. However, the tax cuts has almost no effect on competitiveness and there are some ominous signs. In the first half of this year the extraordinary growth in germany did not generate enough export oriented economic activity to have offset the decrease elsewhere. If the world ecopnomy will slow down Hungary can find itself trapped again. Beyond this worrying possibility one should take into account the ongoing sovereign debt crisis in the eurozone. If in March, when Ireland will return to the financial markets its yields will still be too high to lend credibility to its claim of beginning to reduce debt as a ratio of GDP the whole edifice can collapse, bringing down Hungary as well. Meanwhile the world economy is inchoing towrads "currency war", a series of competitive devaluation, a dangerous development to the export capabilities of the EU.

As it seems although Hungary freed itself from the the IMF (but not from rules of the EU, that are much less flexible) it did not gain a larger influence on these exterenal factors. While countries had a chance to really negotiate measures with the IMF, and that way implement an economic policy - at least partially - of their own making and enjoying the safety of having the support of this institution, now the Hungarian government acts in the hope that every single external factor it can not influence will at the end contribute positively to its economic plicy. In this sense Hungary is less and not more independent at the moment, its future hinges exclusively on the positive developments in the world.

I do not want to presage an inevitable failure of this new policy, although I have not much confidence in it. But even if I try to make this generous gesture of fair play I could not escape feeling myself as a white mouse looking out of a cage juts before entering a labyrinth in a new laboratory experiment.

* Please note, the owner of this blog doesn't concur with any of these opinions, considering them very simplistic if applied to Hungary's present state of affairs and in general as well.

** One should pay respect to the few exceptions, most notably among the Peter Attard Montaldo at Nomura, who echoed suspicion from the beginning.

*** There could be many reasons for this surprising development. One of them is certainly the process of deleveraging, especially as the fx-based loans were hit by the rapid deterioration of the exchange rate of the HUF against CHF and EUR. People probably pay higher mortgage rates from their higher income, something that could easily last for years.

An action plan of indecision? Updated

Hungary's new prime minister, Viktor Orbán announced yesterday his "action plan" a set of measures seen as the guidelines of the government's economic policy. The announcement followed days of insecurity caused by remarks of Fidesz and government officials on the budget deficit this year, frequently using phrases "like Greece", "default" etc. This debacle (retrospectively Fidesz politicians - speaking only from behind the defense line of anonimity - hinted to a conscious strategy, but the party has a tendency to reinterpret every failure afterwards into a plan of a mastermind, therefore it is less and less credible with time) signaled the abandonment of earlier ideas and the realignment of the possible policies.

Anyway, the prime minister delivered a very conscious speech conveying the will and energy to achieve his goals and announcing 29 measures. It had an immediate effect, it was certainly a good show of an illusionist, especially among Hungarian analysts, whose obsession with flat-tax is almost a medical case. Many of them hurried to hail the greatest structural change of the last two decades etc. And the impression in general was certainly favorable, on the surface the new policy seemed to be really well thought. Nevertheless, if scrutinized with a more critical eye - without allowing oneself to be deluded by the flat-tax - it is a surprisingly empty and astonishingly not elaborated package.

The starting point was that the government has to achieve a budget deficit as high as 3,8% of GDP this year, because the IMF and the EU (espacially the latter) would not let them to raise th target to 5-7%. However, Fidesz promised a "tax revolution" in the campaign (although it was clear that they couldn't decide whether to opt for flat-tax or a family-tax system, copying the French model) and tax cuts for enterprises. After they lost a lot of room for manoeuvre when they had to accept the lower deficit figures they still stuck to this idea and decided to find other sources of revenues to offset the income losses. The solution was imaginative but not quite convincing: the banks will pay a half of their profit to the budget in order to allow them to relax the tax burden on individuals and on other companies. Besides the 16% falt tax combined with the family tax the prime minister announced the reduction of the wage costs in the public sector, reduction of tax on companies' profit (at least for those who has a profit less than 500 million HUF) from 19% to 10%, complete freedom of distilling spirits for individuals (really!) a freeze of public services fees for the population, a ban on mortgage based fx-loans and some symbolic measures, for example reducing costs in the state sector and subventions to political parties.

However coherent it seems (and the underlying idea, even if its is horrific, is really coherent) it do not need a Nobel-prize winner to discover how scratchy it is nd how much it lacks the essence of political action: decision on some core issues and acceptance of confrontation. First of all it is still not a decision to fuse two tax systems based on very different principles, it is the opposite: an escape from decision. Considering this state of affairs it is not quite surprising that today none ion the government was capable to give information on details. There will be something with a 16% flat tax rate and with tax breaks and credits for families raising children, but to wich amount the latter will extend, what will happen with the so-called "szuperbruttó" in the present system ("super-gross calculation" an effective extension of the tax base, it taxes the ammount of the social contribution as if they would be part of the income itself) and the tax rebate. Even more serious issue is the problem of "lower wages". The present system - due to a very extended tax rebate - lays only 16% tax on a monthly income of 230000 Huf well over average and median wage in Hungary. The elimination of this part of the system was announced - in two years - which at first sight will effectively mean a tax hike for everyone with 230000 Huf or lower income. There were hints that the government will ensure that no one pay more, but there seem to be no other solution than to raise wages, but an effective 20% wage raise will not deliver one if the most sacred result of as flat tax system (at least in the eyes of its adherents): lower labour costs. (On the idea that it will create incentives to present previously untaxed incomes for the tax authority you can see my earlier post. The very theory used to support the flat tax contradicts to this idea. There is no evidence, ECE countries with flat tax are more infected with black and grey economic activity than Hungary, according to every estimate.)

Similarly vague is the idea of the reduction of costs of public services. It is even not clear whether this applies to the entire public sector, only to certain parts of it or to the state owned companies? While the prime minister mentioned 120 billion Huf as saving for this year and referred to it as 15% reduction of these costs, the only concrete measure was a 48 billion reduction at state owned companies. (But it is tricky as it is the 15% of the wage bill for the entire year while the cuts will come in the second half. The result: 25-30% for six months!) Whether public instiutions, ministries, authorities or schools, the health care sector etc. will bore the remaining 72 billion or just a part of it it is still not clear.

The freeze on public services prices was declared to be temporary, until the government negotiates something with the respective companies. However, price control will soon be reestablished. The bank tax announced without preliminary consultations. Even the method of "liberating" spirit distillation is not clear., it is at the moment not more then a wish list without calculations. And it is based on a very tight calculation, without any reserves and always counting on the most optimistic scenario. If the bank tax falls of or fails to deliver the necessary amount, if growth will remain sluggish the deficit will soar up and austerity will settle to other sectors. Moreover, even the real extent of tax cuts is not clear, because no one knows the amount of family tax breaks and rebate and the future of the present tax rebates. Therefore no realistic calculation of the effect of the package on the budget is possible. (And no structural reforms - some percentage points relaxation in an already almost flat-tax system is far from being one, across the board cuts in the public sector can also be seen hardly as such,Gyurcsány would have been ridiculed by the same "analysts" with a similar action plan who are now praising Orbán.) We have seen the sorcerer, the white rabbit was fat and juicy but it evaporated in a day....

However, the direction is clear: redistribution of wealth from the lower strata to the rich (the very rich) and from the poorest regions to the richest quarters of Budapest. It's negative effect on local economies is predictable as purchasing power will dissipate (while the positive effects of creating jobs is doubtful at best, the recovery could easily turn out to be fragile with the austerity programs of EU governments, the most far-sighted ideas of the Fidesz program were postponed - investment into energy efficiency, for example - or even thrown off etc.) and already huge differences in the country will grow. Well, the show was excellent, but the road is still covered by thick fog.

Update: So, we have a plan with the aim to keep under control the budget deficit and boost competitiveness through lower labour costs. But the secretary of state in the ministry of national economy responsible for tax issues announced today that the "szuperbruttó" will be eliminated and no one will be worse off in the new system (i.e. no one will have lower net income) than in the old one. No details, of course.

But even in this very basic and vague form the plan seems to be way off the announced aims. If the government will pressure companies to raise wages it will negatively affect labour costs without an equivalent raise in productivity. At the moment the average wage of 56500 physical workers in the agriculture is 109746 HUF. They would need a 12,2% higher wage in order to have the same level of net wage. But it would mean an additional 3,5% in higher social contributions as well. Similarly, the (non-existent) average industrial worker (441900 people) will need a 7% rise in wages what would mean an additional 2% in social contributions. The 195900 workers in the commercial sector will need a 10,7% higher salary, an additional 2,9% burden in social contribution. Moreover, the state employs hundreds of thousands of public sector workers and teachers, nurses etc. who also will have to enjoy the benefit of higher salaries in order to offset negative effects - if the secretary of state mentioned above told the truth. 3,5% raise for average employees in the health care sector (148300 people), 13% for physical workers in the same sector (90200 people), 10% for physical workers in the educational sector etc. Certainly more than 30 billion HUF just in order to compensate them real wages still declining. It is still not a well thought plan, just improvisation.

On taxation II.

Although in the previous post I mentioned macroeconomic context of taxation as the topic of this follow up post, as a layman I do not want to claim to analyze the issue in depth. My aim is only to pick up some themes  - some frequently mentioned in the public discourse, some totally absent - I find intriguing, nothing more.

The whole problem is centered around the redistributive role and the distortive nature of the taxes in the economy. From this angle taxes serve to channel money (capital) from the economy and from certain parts of society to others. As a discretionary levy on income or capital they nature is to change the incentives of the free market and pulling or pushing the economy out of its natural balance. (However, as some functions of the state are considered as necessary - setting the rules, guarding property rights, carry out judiciary decisions etc. - and their exercising is only plausible with some state revenues to a certain extent this distortion is unavoidable. But the extent is disputable and disputed.)  The first issue to be discussed here is the redistribution, whether it is negative under the present circumstances - i.e. in the crisis and with the necessity of tight fiscal policy narrowing consumption as a driver of economic growth. It is a specific approach, far from claiming universal validity.

An appropriate starting point is the model of the last decade (or in case of the US even the last 25 years) Income and social differences has grown in many Western and ECE countries. In the US it is usually associated with the tax changes, preferring - at least relatively - those in the upper income and wealth categories and in ECE - especially in the last decade - it is a result of the foreign direct investment based growth. (Although the necessity to follow this path and the possibility to find a different growth model is a topic of frequent contradiction, for my post the existence of this model will suffice, and it is not a prejudice regarding the merits of this path.) Nevertheless, as the US economy is based on internal consumption and in the transition countries the long period of subdued consumption led to a widespread desire to acquire the goods neglected during the change. The result - to sum it up simply, thus a bit simplystically - was the growth of credit aimed at consumption as real income growth couldn't serve as the basis of increased consumption. 

But why it is a problem when the growing national income - as in almost every country long and protracted periods of growth characterized the last decade - is not redistributed heavily, thus leading to growing income differences? Leaving aside moral considerations and not claiming that it necessarily fits to every situation one issue was the sustainability of the growth path. It is usually presumed that people with lower income tend to consume more as the ratio of their revenues ad to an extent it is true for additional income as well. This is mainly based on the fact that they usually can not satisfy their needs and desires because they disposable wealth is not enough. To the contrary, those with higher incomes, although spending more nominally, can easily save a higher ration of their income as it is significantly higher than their needs. (It is worth to note that the propensity to consume is influenced by social behavior as well, either on individual level or in societies with higher savings rate the consumption ratio can be relatively low even in lower income categories.) In general higher income of people in lower strata is perceived as a more certain way to drive up consumption, while the opposite is rather advantageous for higher savings. But it also means that if cheap credit is available for everyone, those with relatively low income can afford consumption. However, if one considers sustainability, the latter case is more problematic, as to keep the same growth rate without providing higher incomes means the constant raise of outstanding credit based on the rise of asset values. Conversely, as soon as asset values decline a credit crunch can easily occur. Beyond this "practical" problems it is also a debatable issue whether asset values can rise indefinitely.

A usual counterargument assumes that the economy is a closed system in which revenues are either consumed or saved and saving lead directly to investment increasing production on the long run. Therefore the higher savings rate of upper income categories is not directly affecting growth, as what they save is equally productive as the consumption at the lower stages of the ladder. In a closed system where financial tools are destined to transmit resources from one segment of the society to the other directly it is probably true but, but it is not so easy to determine whether modern savings techniques results in this very straightforward relationship. Moreover, due to the reliance of these savings techniques on the creation of the money in the financial system in order to create profit (it is the very basis of a financial bubble) even the channeling of savings into production is questionable. Not to speak of the difficulties of identifying the destination of such savings in geographical terms. It is probable that savings from Budapest will land in production in Brasil and this uncertainty again reduces the validity of the above mentioned model. The system is far from being closed and the relationship between the sectors are less clear and direct - due to financial innovation and globalization - as it was once. (An important aspect, tackled below is the profitability, whether financial investment brings less, equal or more profit as investment in production.) 

At least two consequences of this state of affairs have an impact on the considerations regarding the desirability of taxes and redistribution as a means to drive consumption. As the need to enhance competitiveness seems to grow instead of decreasing - due to the structural problems export is the favored way to create a current account surplus and cut down debt/to GDP ratio - wages can not be raised significantly (or only net wages through tax cuts, but the limitations of such measures to raise net income was the topic of my previous post) and it will limit the growth of consumption. If this driving force of the economic activity would need to be enhanced - and this is a matter of further consideration - the only feasible way seems to be redistribution as it would channel wealth from sectors of the respective societies where it is even not necessarily plays the role of being the source of investment to sectors where it could serve as a resource of consumption. (However, as the environment is rather inspiring deleveraging, getting rid of existing debts through savings it is far from being certain.) But beyond this - and probably more important - the validity of the model of government outcrowding is less plausible as it is treated in the public discourse. (This model relies on the assumption that private income is either consumed - that way poured into the economy - or saved - and the savings are directed by the financial institutions to the economy as sources of investment. The government's intervention - through collecting taxes - hijacks valuable resources and detours them. Although it is acceptable to a certain extent, if the government removes too much money from the private sector - especially if it happens through deficit spending covered by borrowing. In this case it usually assumed that less risky - and sometimes more profitable government bonds are more attractive to investors than company's bonds or savings accounts. Therefore the government collect and redistributes the money that would otherwise flowing swiftly into the economy. (The extensive taxation  has similar effects, as in this case the government directly expropriates the money it needs.) However, in the light of the globalization and the less than sure utilization of private savings as investment or domestic investment it is very doubtful. 

Firstly, as long as cheap credit flooded the world both the government and private sector was capable to draw on significant resources, irrespective of the prospects of return. No real outcrowding effect was detectable for example in Hungary, albeit one can ague that interest rates were higher than would have been without government imbalances. But - due to cheaper foreign currency denominated loans - private sector was capable to finance itself despite the huge volume of government sector borrowing. Secondly, nothing can ensure that savings not absorbed by government sector will be utilized by the private production sector. Even though some impact of government imbalances on the distribution of scarce resources can not be denied the original - and even today very popular - model of direct outcrowding seems less plausible. (Or, more precisely, it became pro-cyclical. While excess liquidity existed outcrowding was not a real issue. but after the collapse of the financial markets it reappeared in an enhanced form. But this time not the individual governments affected the economy, but those states that has the ability to borrow in their own currencies. Therefore, US government and Treasury bonds replaced ECE government bonds in the portfolios of investors.) But it means that the relationship is more refined as usually perceived and as a consequence it is dangerous to assume that reduction of government debt will result in a similar rise in private investment or consumption. (Especially as imbalances has to be dealt with and deleveraging is a universal phenomenon.)

This is not independent from the other important issue, how far taxes are distortive regarding economic activity and whether tax cuts in the EU are measures to release economic forces from their captivity or rather government subsidies that should be banned just as direct government subsidies are. The starting point is again the concept that taxation - even if it is undeniably necessary - is a distortion of the market, regardless of its extent. Even if better or worse tax systems can be conceived in this sense this idea clearly creates a binary opposition, taxation opposed to the tax free economy.  And if someone presumes market distortion as bad or at least disadvantageous taxation can not be seen as acceptable, only tolerable at best.  A tax free economy should be treated as better suited for optimal distribution of scarce resources than an economy with taxation. As a consequence any kind of change in the tax system is rather a redirection of this distortion, a change of who is affected positively and negatively but not the removal of negative effects in itself. But as long as distortion of the tax system exists why not to treat this redirection identically to the direct susbidies? It expresses preferences just as subsidies do, it forms obstacles in the development of certain industries - some of them would be in a more advantageous position without the taxation - while offering more favorable conditions for others. 

Beyond these rather general considerations one can also ask whether tax modifications inside the EU can be justified? Even if one would argue that there are more market friendly and less market friendly tax systems and therefore modifications of the system reducing distortion can be designed (and it would be a serious counterargument to the above line of reasoning) it wouldn't eliminate a twofold problem inside a perceived common, single market, like the EU. Firstly, as even this counterargument would accept the possibility of tax modifications with negative effect on the economy (and serving as indirect subsidies), every single step would have to be judged individually from this perspective. Even though a common framework of taxation exists its effects are rather moderate, well reflected in the diversity of VAT system, even if the EU regulations set - nominally - a very strict limitations on their variations. But another problem - already tackled in one of my previous posts - persists: whether modification of the tax system is acceptable at all in a common and single market as the EU is usually seen? 

Every member state became a member of the economic community with a given architecture of its own national economy - brought in line with a set of regulations of the community - and joined this peculiar organization while it also had its own internal economic architecture. As soon as the integration was carried out - for example derogations were phased out - it was perceived to be part of this single common market. How far unilateral modifications of this internal architecture can be acceptable and when does this activity start to be contradicting to the idea of fair competition? The treaties are rather silent in this regard. They identify a series of fields were larger unity and conformity of the member states is expected an others were it is not desired rather arbitrarily? Why is it an aim of the EU to form a currency union - theoretically leaving no opt out for anyone - while tax systems are considered as almost exclusive territories of responsibility of national governments? It inconsequential at best. If the union is a given common market than every single unilateral deviation from the pre-existing conditions should be treated not only in the context of the respective member state, but in the context of the union as a whole. Favoring ones own country can be disadvantageous for others and such moves are considered as contrary to the idea of the common market in many cases. Why not in the case of taxes? Even in the case of tax cuts? Anyway, individual companies made decisions earlier according to given conditions and a deliberate change in these conditions undermine their reasoning, resulting in very real disadvantages that could not have been presumed.

Unfortunately not only the existence of the EU makes the practice of constant tax cuts a bit dubious from the perspective of a common market. Tax cuts can be interpreted as very direct subsidies for companies and their owners in the context of the difference between financial markets and investment into production sectors too. One of the reasons of the financial investments stronger appeal compared to investment into production (noteworthy is the growing share of financial companies from the GDP of the US in the last two decades) was the higher return on these asset classes. Seen from this angle tax cuts or tax rebates for companies are nothing else than premiums on this investment to make it competitive and attractive enough. But in essence it is the same as giving direct subsidies. The state gives public money to private companies in order to counter market forces' effect on their activity. Moreover, to the extent this assumption is true even the perceived results of such tax cuts and advantages - more investment in the private sector because of the higher return - can be questionable. If the tax advantage is just an investment premium to complement profit it is not certain that the additional income will be used this way. 

However, the matter seems to be complicated by the possibility to trade shares of individual companies on the markets. The rates of these shares are usually seen as a good reflection of their real market value, based on their activity. therefore on their real return in the form of excepted dividends. But it is not necessarily the case, it is an epistemological problem. Shares are traded as if they would reflect real activity, but it is not necessarily the case. In many individual cases it turned out that the company was capable to deceive the markets. (Remember the Enron.) Sometimes it is even beyond the individual companies and whole systems can fall victim of such practices, like the banking systems in Spain or ECE today, with their huge mortgages not written off or reduced to their real value (expectable return) rather kept overvalued in their books. In any case the possibility that the markets has only a chance to follow developments in companies and react to them with a lag - despite every kind of sophisticated means to evaluate their performances - because ultimately they have to rely on information supplied by those companies. And even if the markets are seemingly following real developments there is always a chance that their reaction is exagerrated. Who can really decide whether the volatility of oil prices in he last two-three years properly reflected the supply and demand and was not distorted by "speculation", the actions of market actors who only trade with virtual oil?

As long as the markets can rely on money creation in order to acquire different assets and trade them the very existence of the capability of banks to create money consists the chance to drive a bubble, completely distorting prices, dissociating them from "real return". And the same bubble devalues the investment in other sectors than the financial. And if the rising stocks themselves provides return for investors - thorugh derivatives, transactions like swaps etc. - not the dividend of companies, making the relationship between real activity and investment return even loser. As long as this situation exists, investing otherwise is crazy, making such premiums as tax cuts inevitable to attract capital. 

A logical solution would seem a regulatory drive making financial assets less alluring and redirecting capital to other sectors. It would necessarily mean a devaluation of financial assets as well, because the expected return on them would immediately decline making their present value lower. Unfortunately it would mean a devaluation of those funds that will finance the pensions of the next generations, the life insurances of individuals etc. On the other hand one have to face the reality: if the growth of financial markets in the last years was the result of a bubble than excess liquidity has to exist in the system. Up to this moment this excess liquidity was not removed, rather moved between different entities. Central banks and governments stepped in and took over private debt (one of the embodiments of this excess liquidity) and transformed it to public debt. But it is not elimination. Could it be seriously hoped that the problems would be resolved without its removal from the system? At the moment the solution preferred by markets seems to be fiscal austerity, cutting wages (but not reducing the debt covered by those very wages) and prices not only in order to generate growth through export, but in order to reduce the public debt that was grown substantially by the takeover of private debt. The issue is whether it is the optimal solution in terms of distributing the pain between social actors (as there is hardly any painless way to resolve the problems) or inflation, restructuring and other alternatives would offer socially more acceptable ways out of this mire. It certainly deserves wise judgment and a broader horizon than that of the "experts" and "analysts". Unfortunately even broader than the horizon of the usual politicians.

Something worth to read - from Barcelona

One piece, one author, two versions. Worth to read...

Casino Royal? Reminiscenses of my childhood

This blog tends to be quite boring, I must apologize again, but instead of the announced posts on Romania or Germany (later, later...) I felt an inspiration to share my views on another funny personality from Hungary. The pretext to focus on his deeds is an announcment from last week that his construction company will establish a huge complex near Pratislava/Pozsony with hotels, a casino, a spa etc. The plan is grandoman one, although not without precedents, Hungary was somehow a favorite location - at least tehoretically, as no plans were realized yet - for companies to build a European Las Vegas. One of these attempts is under investigation after the company was accused to manipulate with the swap of territory with the state, another one is allegedly on its way to realization, suprisingly quite close to the place where this new complex is planned. Anyway, casino and the turist flow awaited from such an enterprise seems to be an object of desire for many entrepreneurs. In this case 1,5 billion euro is the invested amount.
It is strange to see the extent of reverence this businessman is treated. As if he would be a genius. This time the announcment was covered with a badly hidden feeling of disappointment and loss, with sour remarks to the Hungaian burocracy and environmental movements because they are blocking the realization of similar plans in Hungary, without any doubts regading its use or viability. If Demján embarks on this project it should be a kind of Eldorado, imply these recations. Not to speak of an alleged 30000 new employee and a 5% rise in Sovak GDP. Obviously, it was also unavoidable to read some sentences on the superiority of the Slovak tax system and state policies, especially as the manager of the planned construction works emphasized this factor behind their decision.
This small and in itself not really significant story is a very good illustration of the lack of critical approach and a servient and self-submissive stance in the public. Demján is treated as an economc genius, Slovakia is the object of our desires and every statement of a construction company - clearly biased - is accepted at face value. The general mood resembled a disaster. (The ironical side of the story is that one of the newspapers, Népszabadság, a couple of days later published a report from Bratislava/Pozsony infroming the public of the doubts raised in Slovakia itself...)
However, Demján was never an economic genius, at least not in the sense being a good economist. Hew grew influential as a manager of a state run chain of deprment stores and later he represented a Canadian businessman from the field of construction, Peter Munk. (Maybe the company usually described as his is still owned by Munk...) It is hard to escape the impression that he never has risked his money and got rich using someone else's. But it is simple jelousy, I wont deny. The real paradox of the story that Demján for some years advocates a strange economic policy for Hungary. (As he is accepted without doubts as an economic oracle he had a lot of opportunity to explain it...) To get rid of every "non-productive" sector and focus - i.e. support it with every possible means, subsidies, tax cuts etc. - on industry! And no one ever asked Demján why is he building instead of producing? Why is he inclined to establish a casino when he could have establish a factory? No one ever became curious of this strange contradiction. Apart from the reality and the reasonability of such proposals it recalled a very old - and as I believed outdated - notion of (vulgar)marxist concept: the comprador bourgeoisie. A social group subordianting everything to the interests of foreign capitalists and making gains as the representatives of it...

Recovery everywhere - why to be scared?

Back from a long summer recess, although the lack of posts recently was not due to my activities (however overburdened I'm am with tasks and responsibilities) rather the lack of impulses and events. One could have seen a rising tide of good news (maybe even the favorite color has changed from green to a more ripened one), a series of countries posting positive growth figures for the second quarter (quarter-on-quarter, in yearly comparison it is rather pathetic) and economic sentiment soaring almost everywhere. As the latter is considered to be a so-called "leading indicator" (i.e. signaling in advance the trends of the respective economy) further economic expansion is expected in the coming month. The change was abrupt, and rather peculiar. While only a half a year ago (almost) everyone forecasted that the world is doomed, now (almost) everyone is prophesizing that our torture is already ended or it will soon end.

A new all encompassing science - the social biology of our age? Some provocations

At the beginning of the last century for many people the biology seemed to be the universal science, not only explaining the laws of nature but at the same time being applicable for the human society as well. Medical doctors, pioneers of genetics, ethologists saw the human race as living in a natural organism and behaving according the laws of nature. Social-darwinism achieved a certain popularity, individuals and nations (or countries) were seen as inevitably competing each other and for many, who were read to draw the inevitable consequences the emergence of superior and inferior nations or races were the natural course of history, supported by the laws of the nature. Based on the latter they thought themselves capable to prescribe the only possible social organization, assign everyone his or her natural role.

As these ideas - even if unintentionally - were present at the birth of and served as a root of the extremist ideologies - fascism, nazism - now they seem to be compromised and even though some scientist from the field of biology or medical sciences are today still convinced that the nation as a natural unit of humans could be explained by and should be organized according to the natural law, nobody really take them seriously. But if someone considers a bit more thoroughly the - rather vulgar - version of economics - or economic prejudices - prevalent today, some striking similarities can be discovered easily.

Why do statistical offices exist?

My preferred Romanian politician, Mr. Băsescu swung into action today again. At a conference entitled "The Future of Social Change: 1989-2009: Visions and Perspectives after 20 Years of Transition" he vigorously attaced the lazy and populist Romanian politicians as - according to him - Romania is in danger to become a country of peoples depending on social assistance. Mr. Băsescu - who recently began to play safe on economic issues, he even contradicted the optimistic forecasts of the Chair of the National Bank and predicted a lasting contraction of the economy - interpreted the facts quite peculiarly. It is probably true (I havn't checked it, I only rely on other data) that a half of the country's nominal population receive regular social assistance in the form of some payments. (It is actually more than half of the real population, as millions are working abroad.) But the alleged reasons for it - populist politicians, except Mr. Băsescu himself, of course, buying votes with social transfers - is a gross oversimplification of the social processes of the transition period.

According to official data the number of employed people in Romania, a country with a nominal population of 22 million, and a real one somewhere between 19 and 21 million, is at around 4,6 - 4,8 million. (Just a slight comparison: in Hungary, a country of 10 million, where the official rate of employment is not higher than 55-56% the sheer number is 3,7-3,8 million.) Moreover the ratio of active people and those who receive pensions - either regular or so-called agricultural ones* - is below 1, at around 0,98. That means: less than one working Romanian bears the burden of providing one inactive with some kind of benefits. It is usually not considered to be a healthy and sustainable situation. (It is true that the financial transfers of guest workers make this picture less disastrous, but as it is unofficial the state can not lift its responsibilities using it as a pretext, nor enjoy some decent income from it.)

The phenomenon was a result of the transition itself, when - not only in Romania, but in many other ECE countries - the suddenly rising unemployment was "cured" by allowing people to escape into the pension systems, momentarily relieving the states from the discontent of its citizens, but in the long run causing ever growing demands on the social systems. But even retrospectively it is not clear whether this treatment was a complete failure or more logical than it seems. In many cases (Hungary, Poland, Romania, Slovakia) the respective economies never really regained the lost workplaces (in Hungary the volumen is 1 million!) and even though outmigration was a factor rapidly depleting the reservoir of unemployed people in some cases (Romania, Poland, Slovakia) the rate of unemployment remained high. (Romania was seemingly an exception, but with the huge number of pensioners it is only a statistical trick.) The FDI focused policies were not capable to ensure a low level of unemployment in two decades and with the crisis hitting ECE and undermining the former economic model it is not clear whether the nearest future will bring further opportunities.

The situation is aggravated by the fact, that Romania experienced a long period of sustained high inflation and the wages remained relatively low in order to achieve competivity. The former led to a rapid loss of real value of social payments, the latter led to the necessity to rein in state income - due to lower taxes - to give a bit more to the "ordinary people". (It was also a core element of a perceived competivity advantage, although personally I consider this argumentation dubious.) Nevertheless, state income remained low not allowing to raise social spendings, but at the same time personal income was not growing rapidly as well (except in the last two years, but it was a result of overheated economic growth, tightening labor market, therefore unsustainable, and even with this rapid rise average wages remained the lowest in ECE, except Bulgaria, somewhere around 250-300 euros a month. Therefore it is not surprising that not only pensioners but other social groups need state assistance for various reasons. (For example some subsidy or support to the natural gas consumption, that can amount in winter months higher than the monthly income of a family.)

But, not denying the role of populist politics, in Romania and in other ECE countries, the main factor behind the extended social provisions - and their limited effectivity as well - is the process of transformation itself. There is no better example for it than Romania, with its large poverty stricken social sectors, shabby infrastructure (a source of balanced budgets in recent years was the lack of investment in those areas) lifting costs of social services and low wages in order to ensure competivity. From this perspective, Mr. Băsescu was not right, rather he completely missed the point: it is not a a shame but a necessity to be a nation of socially assisted people and the only option to alter the situation is to get rid of every kind of social responsibility of the state. (Even minimal ones, as for example average pensions are not higher than 100-150 euros per month, not a huge amount for decent living, but a real burden on a state household determined to lift every tax from enterprises.) But even in this case there would be a half of the population left without the necessary means for a subsistance.

* In Romania two pension systems exist, the regular one and the so-called agricultural. The latter is composed by people earlier working in agriculture during the communist era and paying contributions into a separate system.

Uspide down - Tax cuts, free market and distorting subsidies

Recently I was pondering the idea that the practice of tux cuts (more precisely cuts in the contribution to social security payable after the salaries) represent - at least in the context of the European Union - a kind of - reversed - state subsidy for companies and that way not only being distortive in the free market but implicitly contrary to the basic ideas of the Union. Of course one should presume as a starting point that the tax-free economy never existed and therefore we could and have to compare the effects of such moves to the existing conditions in Europe and not to the highly idealistic concept of the tax free economy as the less distorted and less regulated , as a consequence the real free market economy. But this premise is the easier to accept because it would be not only ahistorical to make this comparison with a theoretical concept never ever realized, but it even would violate such ideas as the theory of comparative advantages, not really foreign from the theory of free market.
If one takes the EU not as a conceptual phenomenon but as a historical entity integrating earlier separated markets than in every given moment the integration is nothing else than a single market in which different - national - regulations can be considered as inherent elements of its architecture and therefore being a factor in determining comparative advantages. This approach - and the acceptance of the idea and ideal of the EU itself, the concept that it is a market where every single actor competes with everyone else - allows us to consider taxes and other contributions as factors of individual choices regarding decisions of production (what, where, with what kind of factors of production etc.) . If we can rely on the idea that every actor is rational, than the differences of the taxation systems will be part of those choices and therefore the distribution of companies and production throughout Europe will be the optimal one considering every factor. (Well one weakness of the argumentation that it is not quite clear from which date can the EU be treated as such market, or is it possible at all at the moment. But let's assume that since the Maastricht Treaty it is in fact a really dominantly common market where every actor has a horizon beyond the national economy and the differences in national regulations constitute elements of this common and single architecture causing comparative advantages.)
The key is whether we accept the idea of an existing common market, because in this case every change - achieved not at the European but on a lower level - affecting the architecture of the market distorts it, because it modifies the equilibrium. Every tax cut distorts the market, disfavor companies whose earlier decision was quite rational and in line with the common market's characteristics, while favors companies whose earlier decisions were poorer. (Once again one can assume that the different tax systems in themselves signal the non-existence of a single market, but at least equally feasible is the perception that the lack of customs and harmonized regulation frames a market and not taxes.)
But the phenomenon is even more interesting in the special case of Hungary, where the main idea at the moment is to lower labor costs in order to make hiring new workforce more attractive for SME-s. The peculiarity of the idea lies in the fact that these companies - while contributing to the GDP with a forth of it or so -, uses at about 20% of the allocated capital and employs almost 70% of the workforce. Anyway it is rather the lack of capital that restricts their expansion and not the lack of workforce. (One can imagine the productivity figures with these factors.) It is quite possible that the new employees will have a zero or negative marginal product, what means that the tax cuts will effectively subsidize production otherwise bringing not profit but losses. That's the textbook example of distortive subsidy, I would say...
Well, I know that thing are not so simple as I presented above. Moreover my definition of a single market is not incontestable. But otherwise I would hypothesize that even in other concepts of the single market tax rates and systems would converge to each other in a similar situation - because of the competition for investment etc. - and not to zero, as it is the case in today's Europe. Or is it not a strange process?

(I know that once again there is nothing revolutionary in this post, but it was a self-pleasing activity to provide the argument and I'm a sinner in this regard.)

Welcome to the machine?

As I was reading the "letters to the editor" pages of the weekly "Magyar Narancs" today, some intriguing thoughts occurred to me, as part of a debate on an op-ed piece some week ago the author of the original article criticized his opponents approach to public services. He denied that the state run and regulated, obligatory systems, like the pensions, health care, social benefits etc can be perceived as similar to markets, expressing the balance of supply and demand. (Well, it is a bit vague but it is not my intention to write about the debate. The point is that the, let's say traditional, sociological, approach to state run public services and the economical one, confronted.)

Chaos unleashed – Hungary in the Maelstrom

Four days after the announcement from premier Gyurcsány about his willingness to abdicate, the following events were very much in line with the predictable. The socialists are almost unanimously denounced as the roots of all evil; the first contemptous articles full of rage and triumphalism were published; the media is dominated by the expectations of the business elites regarding a prime minister convenient for their own interests, of course portrayed as the absolute public good; the president of the republic urged early elections; the socialists are in disarray, mainly only sticking to their positions and not to values or an ideology and we still don't know whether at least a new government will be installed or the dissolution of the parliament is inevitable. (Well, otherwise, everyday life seems not to be affected very much by the events. Hungary is a pessimistic country where passions are boiling under the surface but not outbursting at the moment.)

Conventional wisdom says that the fate of the Hungarian government was sealed by the crisis and the collapse was inevitable. Although there are many elements of the truth in this assumption I tend to disagree with its entirety. Not in the sense that the crisis wouldn't have had an impact on the events, quite the contrary. The decisive moment was the choice of the prime minister in the fall of last year to make an attempt to recover his credibility with effective handling of the crisis and at the same time snooker his opponent, Orbán, with the help of diverse social organization, from whom he hoped for support. He hoped for a reframing of the political discourse and legitimize not only his politics but the reform attempts as well. But the last decision, regarding Orbán, meant that instead of putting forward the structural problems of the world economy in the form of discussing the roots and possible outcomes of the crisis, the responsibility for the events etc. he returned to the earlier problems of Hungary and Hungary's economy, regardless any possible change in the external circumstances, because his would be allies were only interested in those problems. As a consequence, the discourse remained narrowly focused on Hungary as if it would be a sole entity, independent from the world economy, therefore capable to resolve its problems alone. Thus the presumption that the earlier economic policy was wrong and a decisive factor of the crisis, became an implicit axiom of every approach to the problem, that way not strengthening, but weakening the governments credibility, quite the contrary effect Gyurcsány wished for. Moreover the handling of the crisis became entangled with the problem of reforms. Those are not really popular and I suppose not only because of their effects on individual income and wealth. Similarly important is the fact that the vison and ideology behind them is very vague and clearly favoring only a minority of the society. Therefore without a profound debate, it is unrealistic to expect acceptance from those, who would be disadvantaged.

Maybe it is worth to make a short excursus regarding this problems, as it could highlight a very peculiar specificity of the current proposals in Hungary: almost every one of them is aimed to solve a particular problem in the system with a general transformation. For example the most popular version of a pensions reform among „experts” is the cutting of the present pensions with 8-10% and their freezing in real terms. Thus today's standard of living would be offered for today's pensioners forever in order to save money, while at the same time almost every one emphasizes that those are the burden on the system who get early pensions as handicapped with fraud. (The estimated number is well over 400-500000!) Another example is the general property tax, 0,5-1% of the value of the real estate according to the proposals. As the value of real estate expressed as multiple of personal income is very high, it could lead to a new burden not counterbalanced with the proposed tax cuts and especially in the case of pensioners and those with a minimal wage, whose income is tax free at the moment. Therfore they won't receive any easing, only a new tax, that easily could compel them to sell their houses. The main argument supporting this proposal is once again the fact, that many entrepreneurs exist, who pay taxes and excises after a minimal wage, while having a large and luxurious house. But once again instead of making a correction in order to eliminate the specific problems, the proposals are designed to achieve a profound transformation.* Returning to the problem of the crisis and reforms the above examples show one more important characteristic of the respective plans: those usually tend to redistribute the burden favoring the upper income categories and hitting the lower ones significantly and it is comprehensibly not really popular.

Once again putting forward reforms as the way of handling the crisis was clearly a mistake, as it enraged significant groups of the society and the result was indecision and ineptitude. Moreover, as Gyurcsány was hoping for support from those who's plans he was not able to implement, he was at the same time not in a position to attack them and spark a debate in which the responsibility of the rich for the future of Hungary would have been the most important topic. As a consequence came a deadlock, and Gyurcsány lost the remnants of his credibility.

One can argue that it was the only way, not only because those reforms are necessary (something I would like to discuss, even though not in extenso, later), but because the country is depending on the benevolence of the markets and they expect such moves in order to lower the country's risk assessment. I won't be that convinced, especially as the two problems, crisis and reform can be detached from each other. The crisis is a matter of how to pay back your outrunning debt at the moment (the real economy deopends on the recovery of the export markets, first of all Germany) and nobody (especially not the markets) expects the crisis lasting forever or for too long. (The former assumption is almost certainly true, the latter one is more dubious, but we can see every day how markets believe in the easy remedy in the form of some very smart and sophisticated action plan restoring the assets to their true value and they are waiting its arrival in any moment.) Therefore the foremost problem is not how to pay back your outrunning debt ten years later, when according to the expectations everything will be in order again (especially as nobody knows how much it will be, and with what conditions) and not how to pay it back at the moment when Hungary has a short-term credit from IMF, EU, World Bank, but how to pay it back at the very moment without accumulating a huge burden of new debts. If one simplify this problem it is quite clear: the government has to control the budget deficit in accordance with its most important creditors conditions (what are softening from day to day) and with the need to make some kind of stimulus as well. This is a hard task but not necessarily means measures aimed at long term objectives, rather ones that are effective but clearly only temporary. Like cutting the working week with one day in the public service, suspending, but not erasing the so called 13th month pension etc. I would suppose that the temporariness of the measures would make it easier to accept them, the measures itself would portray the government as capable to act decisively, while not necessarily meaning the renunciation on structural changes after the crisis is over.

On the other hand I would suppose that such an approach to the problem would be even advantageous for the quality of the structural changes as well. The most important problem with the present proposals is that those were developed in a completely different environment, when it was easy to assume that the model implemented in many ECE countries as an effective means of attracting FDI brings a fast real convergence and is capable to restrain the accumulation of imbalances. But with the crisis (and with the developments in the Baltics, even before the crisis hit those states) it is hard not to place a question mark after this presumption. Thus it would be deadly important to put two questions not independent from each other: how far are the earlier models valid (especially in ECE) and how will be the world economy emerging from the purgatory of the global crisis? As far as these are not answered convincingly no reform proposal (except some vague and very universal assumptions,like the need of balanced budget etc.) can be treated as well founded because those clearly wouldn't be based on the realities. (It does not necessarily mean that no reform proposal would turn out to be effective and succesful, but it would be rather the result of luck and not of the quality of them.)

If the latter approach would have been prevailed it would have had political advantages as well. Gyurcsány would have had an opportunity to take stance against the unpopular reform proposals arguing that the country needs a solid plan and not one based on dubious premises, to make populist attacks on the „capitalists” or the „bankers” and „brokers” as responsible for the crisis, seeking their own personal advantage even in these dire hours and therefore lifting some of the burden on him and maybe generate a popular rage against them, giving him real political weight after months of minority government when he was treated as doomed to lose his position sooner or later. Maybe he even would have been capable to implement some measures for the handling of the crisis that would have distributed the sacrifices a bit more evenly (for example with a one time levy on large properties, a nice, one time income for a shattered budget), thus making it easier for the majority of the population to accept the inevitable. It would have meant the renunciation on the snookering of his opponent, but maybe it would have been a real chance to reframe the discourse and transform the political situation in order to emerge with more popular support even for well thought changes. It was not a very probable outcome, but the possibility certainly existed. With the abdication he not only accepted his failure, but once again returned to his earlier strategy, waging war as the champion of reforms and modernity and almost certainly lost the real opportunity forever.

*(I know that there are many other supportive arguments for pension and tax reform. But as these reasons surface the most often, I only would like to highlight the twist in this approach, because it is a general problem regarding the different plans.)

Doomsday reports? - notes on exceptionalism V.

Although I have my doubts regarding economic forecasts - especially in case of longer periods - and in these times it is hardly possible to make a prognosis valid even for a few weeks, today's newsreel contained two interesting pieces. The estimated growth of Germany was cut by many economic institues, while a London based research center published a series of prognosis regarding ECE, painting a dire picture of the regions outlooks. I won't discuss these analysis in detail, neither at this occasion nor later, but in this case it is not unnecessary to point out the most important elements, at least from an East-Central European perspective: Germany's recesion is forecasted in the 4-5% range, and as this country is the foremost export market of ECE countries (for example the correlation etween Hungary's and Germany's growth is extremly tight)and the strengthening of internal demand is not really possible due to the importance of the credit bubble in it's earlier drive, it is very likely that the region as a whole will be affected. Similarly important is the revision of growth estimates for the Czech Republic and Poland for this year. Up to this point these countries - with Slovakia - were considered as positive examples of prudent economic policies making them capable to weather the storm. (The specialist press here, in Hungary even now treats these countries as examples of very tiny positive growth in this year.) The forecasts for Slovakia were modified a couple of weeks ago (it has passed the Hungarian public's attention unobserved) and now the Czech central bank, having even in January a forecast of 2,9% growth changed it's view and now they are counting a -2%. The Londoners published a -3% forecast for Poland as well, a sharp reduction from earlier positive estimates and accompanied in this model with a 5% budget deficit as a ratio of GDP. Even though the perspective outlined for Hungary is worse (-7,5%) the whole picture depicts a catastrophic situation. (-15% and -10% in the Baltics, -5% in Bulgaria, -7,5% in Romania etc.and the revision for Hungary are now very modest compared to the estimates for other countries, not that it is very important.) The processes seem to be very similar and even if some differences will remain the direction is the same: no country will remain unaffected, and every one of them is heading towards a very dire ecnomic situation, regardless of earlier "good" or "bad" behaviour. It is highly feasible that at the end there won't be a defence line left on country level, no means to counterbalance the effects of the crisis.

Reflections on flat-tax

The flat-tax, paired with the low redistribution rate is considered to be the key of economic success, so-called miracles in many ECE countries. The Baltic states, Slovakia, Bulgaria, Romania used to be mentioned as obviuous examples. In Hungary, where a one-sided dabete on the problem ensues (economists and "economists", "experts" strongly argues in favor if its introduction, while the socialist party obstructs it, although without the necessary intellectual capacity) these countries are often used as textbook examples of fast growth that substituted the budget revenues lost with the abandonment of differentiated taxation and it is often percived as well, that these countries have, due to their tight fiscal policy, room for manoeuver in this crisis. To put it simply: they have the necessary reserves to loosen their budgets and stimulate consumption either with financial transfers or with invesments.

The present crisis offeres proofs for a very different interpretation as well. According to the latest news I would dare to say, that at least in ECE this mixture of tax-system and fiscal policy led to an ironically pro-cyclical model instead of the perceived anti-cyclical one. Let's collect some data and facts:

a, the Romanian budget collapsed in the last two months of 2009 due to the loss in VAT (the figure of budget deficit as ratio of the GDP dubbled in this period)and the revenues were well under the expectations in the first two months of 2009 as well

b, Latvia is struggling to controll its budget, the 5% deficit agreed with the IMF in last year seems at the moment highly impossible, even a reduction to 7% would need drastic cuts, for example 20% of wages in the public sector

c, Estonia - a country that run budget surplus for years and having large reserves - needs cuts (!) of budget expenses in order to achieve its goal, a 3% deficit in this year, not really allowing the governemnt to take stimulating measures

d, the most striking of all: Slovakia's budget revenues are lagging behind last years figures with 15% (the figure is even worse compared to this year's budget, as that was calculated with a 2,9% GDP growth) and the revenues from VAT are almost 50% lower than in the previous year.

Obviously, there is no room for fiscal easing and stimulus, these countries rather needs harsh budget cuts (or tax hikes) in order to control their state houshold, what is quite the contrary to the proposals of an anti-cyclical policy, even if the flat-tax system was treated as an important factor of the impregnability of these economies.

Once again I have to admit that I'm not an economist, therefore my forthcoming observations are rather hypotetical, a kind of brainstorming, but I hope that not completely without substance. The main question is what caused this unexpected turn of events?

The above mentioned tax systems were made attractive with a relatively low flat-rate, between 10% (Bulgaria) and 24% (Estonia), mainly around 20%. Usually it was achieved with the abandonement of a progressive tax system with high rates for higher income. The restructuring also meant transfer of the focus of taxation to the consumption, especially as the effective lowering of taxes for individuals were meant as means to drive it. As the budget revenues reached their former level usually soon after the introduction of the new systems it was considered as a success. (Fiscal reserves were built by cutting expenses.)

Therefore it is not surprising that with the decline of personal consumption budget revenues are declining as well. But I would dare to say that situation is worsened by two factors, a general one and a specifically East-Central European. We can presume that wages are - at least in Europe - less flexible than consumption even in times of crisis, therefore taxation on income is more predisposed to withstand sudden changes and yield relatively more revenues than based on consumption. (Well on the long run changes are maybe the same, but we are struggling for months of survival until our export markets can restore their demand.) That could mean that taxation systems based on income has more reserves on a shorter horizon, giving a chance for stimulation. (Well, of course only in case of a relaxed state household.)

More interesting is the specifically Eastern-European phenomenon, the possible importance of the credit bubble for the states themselves. Although it sounds very nice that net wages were raised by 10-20-30% due to the new tax systems, as a source of consumption in an area of free trade like the EU it meant less than one would have expected. Avarage gross wages were between 500-800 EUR (630-100 USD) two or three years ago, now they are somewhere between the 600-1000 EUR range. With a very basic calculation we can assume that lowering the tax rate with 10% meant 50-80 EUR in a month, not a very substantial sum, I would dare to say, especially if someone was eager to buy more expensive goods and not only extend food consumption. This sum in itself was not really able to incite a consumption frenzy, but if it was multiplied by credit ... 100 EUR is the monthly payment for a decent sum. Add the effects of the housing bubble to it (mortgage based consumption credit meant in Hungary only a two thirds monthly payment compared to normal consumption credit, inflating the bubble considerably) and it is a very dire picture. I would conclude that the credit boom were necessary to stimulate consumption and through consumption raise budget revenues. It is possible that without this source of income states would have been forced to cut further public services and that way incite public discontent...

Anyhow, if my hypothesis has some basis, the collapse of budget income is more comprehendible. Consumers are saving money, as it is common in times of crisis, banks are not lending money as it is one of the main factors behind the crisis and even if workers are not laid off, the wages are taxed so moderately, that it won't bring too much for the state. Governments suddenly has to cut budget expenses instead of an expansion.

(There could be a counter-argument, that the effective tax-rate in Hungary, calculated as a ratio of the sum of the officially paid wages, is not higher than in these countries - at about20%. But there is at least one significant difference, as the minimal wage is taxed with a very low rate (2-3%) that means a significantly higher rate even in case of average wages. Those, who have higher salaries, and therefore arguably have a better position in their companies, not to be laid off so easily, pay the bulk of personal income taxes, while those with minimal wages are paying minimal taxes, therfore if they lose their jobs - and one can assume that they are laid off in the first phases as they are easily replacable - it is not a loss for the state houshold, even though a burden in the form of unemployment benefits. This tax system is not making individuals cheerful, but it could have suprising - well, relative - advantages.)

Back to the future?

Last April the then-minister for economy, delegated by the liberal party, made a roundtrip in capitals of ECE, where he found fellow liberals in the government. As he was that time already abdicated (the liberals collided with their socialist partners over the necessity of reforms, especially in their form advocated by the liberal ministers after the governing parties suffered a heavy defeat at a plebiscite), it was rather a demonstration of the successes achieved through policies (flat-tax, low social expenditures and redistribution rates etc.) similar to their proposals. At about a week ago this former minister, now chief-whip of the parliamantary club, published an article in the leading newspaper of Hungary recalling this experience, once again arguing on behalf of flat-tax and its accompaniments, at the same time making a hint, rather gloatingly, that he was right even ten month ago.

As Hungary is heavily affacted by the global crisis, besides the government other organizations and institutions are seeking the way out and that kind of ideas has many adherents, actually it is the dominant view among economic organizations (Association of Industrial Entrepreneurs, BIG4 etc.) and among mainstream economists and so-called economists, in fact many of them analysts working for large and not-so-large financial companies, obviusly having more degree form this field than me, but not necessarily as many academic publications. (I must admit that for almost a decade I researched topics of pure or at least tangentially economic history. Even my PhD was conferred for a dissertation on the history of banks of the Transylvanian Saxons, but it does not mean that I have real expertise and will pretend here as someone with economic knowledge.) Anyway, the ex-minsiter found it the appropriate moment to announce that his party was right and it is high time to realize those reforms and at the very same day heavyweight economists (well, it is by Hungarian standard only) threw their full weight behind his party.

Even though there is not much contradictory opinion present in the public, the whole story is highly ironic. As this ex-minister visited Tallin and accompanied by the Estonian prime minister announced the superiority of the Estonian tax-system and the economy fuelled by low redistribution rate compared to the Hungarian situation (he retold this event in the aforementioned article) the small Baltic state already entered the phase of recession (and primarily not because of the looming crisis), predictably a serious one, while Hungary was not yet affected by the crisis. His other example, Romania, from where he once again delivered his message to Hungary, was considered to be on the wrong track of overheated economic growth driven by a housing bubble based on transfers of Romanians working abroad. But, regarding this latter country, even more interesting is the fact, that the revenues of the Romanian budget simply collapsed in the last two months of 2008 (the budget deficit as ratio of GDP more than doubled), in a period when the country was hit by the crisis, because the level of state income from VAT remained well under the expectations due to a drop in consumption. In case of Estonia they are not only thinking of amending their tax system, the Estonian finance minister is considering a lasting raise of the redistribution rate.

One interesting observation can be that these pieces of news were not heard in Hungary, but it is only of secondary importance besides the real questions never asked from the advocates of the same policies as one, two or three years ago: why those measures, allegedly making economic development sustainable, robust and therefore economies impregnable, obviously didn't work? Although there is certainly truth in the opinion that the economic policy of the Hungarian governments was at least sub-optimal in the recent years, in the light of the recent events it is hard to evade the problem whether the ecnomic model emerging after the transformation is still capable to ensure economic and social convergence of these countries to the core of Europe (more sceptical people can even rephrase this question whether it was capable for this task at all) and whether difference in the tax-system and redistribution level is really a substantial difference on the long run?

This one won't be the post of in-depth anlysis, but at least three aspects of the problem can be raised even here, especially as those are not considered by the experts and "experts" who recycled their earlier plans, designed among quite different circumstances.

1. The primary supportive argument is based on competivity. According to those who are still convinced that this is the only way out not only from the crisis but from the lagging growth of the recent years, Hungary and the countries in ECE are competing for FDI and as cost of labor is lower in almost every other country, Hungary has to accomodate to this fact. With tax cuts and budget cuts especially regarding social expenditures (thier rule of thumb is a mechanical comparison, if let'say Slovakia's similar spending amounts to 16% of the GDP, than they has to be followed) and state burocracy. Maybe it is an argumanetation not easy to dismiss but as the flat-tax, low redistribution ratio model was portrayed not only as a rational choice but as the only possible one and as the basis of robust and sustainable growth it is legitimate to point out that no country, regardless of its tax system remained unaffected by the crisis and even some model economies were the first one and many of them are among the most heavily hit. (Not only in ECE, but for example Ireland.) It could raise the problem whether not the tax system, but the very model of integration into the world economy is the real reason behind the effects of the crisis? Almost in every country - the lone exemption is Slovenia - foreign capital played the role of fuelling the economic growth, while goverments, reasonably, tried to accomodate the conditions to the needs of investors, keeping the cost of labor relatively low. But, as it turned out, the societies - in a world where it was easier to compare their standard of living to the Western countries and their production as a result of their work seemed very similar (please, report himself every worker in a factory who knows the real content of the "mysterious" productivity!) and these countries were acknowledged as parts of the West - were eager to catch up with their fellow Europeans. (Own a house, buy a new car, travel abroad etc.) Although tight fiscal policy - especially in Hungary - was promoted as a means of preventing people to spend more then they produce, the integration of the European financial system led to other consequences: people borrowed money they were not earning or receiving through social transfers. We know the result. But maybe both the FDI fuelled economy and the overspending from foreign credit can be structural similarities more important than the differences of the tex system. (Not to mention that those arguing in favor of the flat-tax model in Hungary still use those subtle nationalistic notions and arguments, pointing out countries traditionally seen contemptously by Hungarians, as having overtaken Hungary, in some cases without any basis.)

2. If the relegated position in the Europen integration (someone to the left from me would call it semi-periphery) is a common, structural factor of the ECE economies could the modification (let's call it reform, as those supporting this idea do) of the tax system really result in a long, sustinable growth and real convergence, as it was promised and predicted earlier? (Once it was quite popular to measure how long will it take to reach the per capita GDP level of the EU - on PPP basis, of course - either for Hungary or for its fellow competitors. It was prophesized that 10-15 years is a realistic assumption, with a flat tax system.) Didn't this crises revealed the limits of this model as well? The complete dependence on resources from outside, that can be depleted almost immediately, the abundance of which is hardly to return soon. Can the catch up be realized without profund change in the structures of the economy, a substitution of the industrial sectors based on finishing products, like car making industry, for knowledge based sectors?

3. This question is especially important as the demographic prospects of every country in ECE are very bleak. (Surprisingly, Hungary belongs to the countries with a relatively better future, at least according to Eurostat predictions.) In Latvia drastic drop (30-40%) in the available workforce is predicted in ten years, and on the long run it is forecasted to be a univrsal phenomenon in ECE. The situation is aggravated by the fact, that - contrary to the assumptions of the supporters of flat tax-based competivity - the progress regarding employment was more bound to the emigration of workers than to the alleged positive effects of the lower labor costs on the employment rate. Plainly speaking, the present economic model as it is based on lower labor costs could have a side effect of pushing out a considereable part of the workforce from the country, and their return with time is far from being granted. More pointedly: it is possible that the advocated model uses up the resources of future economic growth even faster then the usual process of making debts and clearly not able to contribute to slowing down the negative demographic process, not to speak of stalling it.

+1 Well, this is the reason of writing the whole post: did anyone, advocating proposals developed many years before the crisis tell us how the future economy, after the effects of the crisis will settle, how it will be reshaped? Will their ideas be really appropriate for those circumstances, especially as the crisis certainly has proven one thing: ECE's integration into Europe is too far-gone? The answer can be dismissive regarding profound changes, but in that case I would expect from those championing this model not to answer with a wholehearted 'no' the question whether the economy will be the same after the crisis as it was before, as they are doing at every occasion.