U-Turn in taxing big firms

Soon after the change of government in May 2010, the new Parliament voted for a “bank tax” – in fact, a surprisingly high levy on financial sector companies. A second package included a surtax on telecoms, energy and large retail firms (typically foreign owned), as part of the fiscal consolidation measures of the Orbán cabinet. The “crisis taxes” would be in force for two more years. A group of 15 companies, including such giants as Deutsche Telekom, E.ON, ING Group, Allianz, and Aegon, wrote a joint letter to the European Commission expressing concerns about policy developments in Hungary. But taxation basically belongs to national sovereignty (except for turnover taxes), thus the levies, imposed unexpectedly during the fiscal year, would stay. Government officials claimed that these companies had made above-normal profit for years owing to lax regulation under previous governments, and were obliged to contribute to the costs of crisis management.

One obvious reason for such surcharges was the yawning fiscal gap in 2010 – mainly a direct consequence of mistaken policies of the previous administration. In addition, the international financial turbulence hit Hungary, an open economy with high public debt rate, particularly hard: the economic downturn reduced fiscal revenues at a time when financial markets and international institutions became very sensitive to high sovereign deficits. Thus the new government led by Viktor Orbán of Fidesz (Young Democrats – Hungarian Civic Party) felt obliged, as discussed in previous issues of this Journal, to take deficit reduction steps. But Fidesz had clearly promised, in opposition and later in office, to heal the economy without recourse to the unpopular and discredited austerity measures placing further burdens on wage earners and pensioners (the “people” in spokesmen’s parlance). Consequently the government saw no choice but to pick on the business sector when additional public revenues had to be collected.

Yet one may find other reasons and additional motives than bare financial necessities behind these tax measures: taxing big corporations, particularly banks, is popular in the present mood.

There is nothing particularly Hungarian in it: big businesses have become lately rather unpopular with European societies. Financial institutions had a particularly bad press and public image during and after the crisis in the countries affected, and with good reason: it is hard to digest for the “man in the street” that taxpayers’ money is poured into cash-rich banks to strengthen them or save them from bankruptcy at a time when thousands of other firms in the real economy go out of business as victims of the financial distress and the concomitant market downturn. To make the case worse: soon after the wave of bank bailouts in Europe and the USA, salaries and bonuses at the top echelons of banks started to return to their pre-crisis height. The old policy mantra has been that the health of the financial sector is a public asset and, as such, it must be protected in bad times. But this received wisdom does not seem to be shared anymore by the public in most societies.

Whether or not such negative public attitudes towards banks and industry giants are justifiable in some objective analysis, public mood certainly influences decision makers: some governments have taken tough regulatory and tax measures to big business since the outbreak of the crisis.

With this attitude change in the background it is no surprise that the government of Hungary, a country in the worst public finance situation of all the new EU member states, took aim at big business, and foreign dominated sectors in particular, making them contribute more through “crisis taxes” to the government budget. Still, this is an interesting case because large firms, and particularly the so-called transnational (multinational) companies, have been until recently treated very differently in all transition economies, Hungary being no exception. Previously, governments of the countries in the region competed with each other for big foreign investors, offering them, among other goodies, preferential tax treatment. Financial and non-financial foreign investors were seen for a long time the engines of modernization in transition economies. Don’t we need foreign funds anymore? Have the positive views on foreign direct investments (FDI) now changed, and if this is the case, why?

In retrospect, for a decade or two, FDI has been the stock answer to structural weaknesses and poor competitiveness in emerging markets and transition countries, but also in developed countries with low growth rate. Most governments have taken serious efforts to promote FDI inflows in the hope of job and wealth creation, technology advancement, and the improvement of competitiveness. East Central Europe became a magnet for FDI once the deep transition crisis period of the early 1990s had come to a conclusion and these countries entered into the phase of buoyant economic growth. It is easy to see the significance of such flows of funds to former planned economies with inherited foreign debt: direct investments add to the stock of capital of the recipient economy, mitigating the relative capital shortage so typical of all countries in transformation. FDI differs from other types of capital flows in that a foreign direct investor brings in non-debt creating funds as well as a technology with potential spillovers from the foreign owners to the domestic economy.

Have these expectations been realized in the region? Results are far from spectacular according to comparative studies (see e.g. Hunya, 2000; Czakó & Zoltay, 2003). Positive spillovers have proved to be less important than hoped for: most major foreign firms have remained rather isolated from the rest of the host economy. The profitability of foreign owned firms started to grow soon after their entry, due to preferential taxation, the competitive edge of foreign firms over incumbents, and in many industries, because of oligopolistic market structure allowing predatory pricing. Return on equity of most foreign-owned subsidiaries in banking, telephony and retail tended to be a multiple of what mother corporations could make in developed countries; indicating that the pay-offs from the market entry of foreign players were not shared proportionally between the host economy and the sender of funds.

Public attitudes to foreign (and domestic) businesses, particularly to banks, are not stationary in society. At first, the well publicized entry of global players into a transition economy fuelled national pride. But the mood gradually changed vis-à-vis big firms, foreign or domestic. The presence of industrial and financial giants is particularly visible in former planned economies. High profiles may provoke mixed sentiments: until recently, arrival of a “multi” has been seen as a promise of better service and of new jobs. Good brand names are most welcome – as seen in the announcement of a major deal, such as the Mercedes car plant being built in Kecskemét in central Hungary, presented officially as a victory for the country and the government. But powerful big firms obviously may provoke negative sentiments, precisely because of their towering presence, even if they care to behave as good corporate citizens (which is not always the case). Officials and opinion makers know well that the economy needs big business; the smaller the national economy, the more important the role that big firms may play.

Now, against this background in official and popular attitudes to foreign investors and big market players, the tough new taxing and regulatory measures mentioned above are certainly noteworthy, begging explanation in the particular Hungarian context.

Changing views and perceptions on business

A critical attitude to big business has of course always been present in any society. It is enough to refer to the numerous American movies with scripts based on a pattern of a lone hero against the cynical and corrupt Corporation. The European cultural tradition also includes sympathy with small businesses vis-à-vis industrial giants. You do not have to be a leftist not to like big firms. Quite the opposite, it became the Social Democratic policy in the post World War II era to forge a semi-corporatist alliance between organized labour (trade unions) and the business community in some European countries – see the Nordic interest-harmonization structure or the German Mitbestimmung as socially sensitive corporate governance. The other pole of the political spectrum, i.e. the centre-right parties, is typically depicted as an ally to business interests. This is oversimplification: Christian Democrats, Conservatives and similar parties do encourage entrepreneurship but they are far from being supporters of big business for the simple reason that the model voter of such parties is the self employed, the entrepreneur, the owner of a small or medium sized enterprise (SME). Such voters do not identify themselves with the interests of the really big firms. Not surprisingly, right-of-centre parties are sometimes more critical with dominant market players than left leaning political forces.

Politics is even more complicated in former planned economies where public views concerning issues such as capital, banks, business, profit and the likes have been shaped by a variety of factors, some of them being very different from those at work in Western societies. Let us take the legacies of the one time official Marxist ideology. Attitudes were, of course, shaped not by brainwashing but by personal experience as to the working of the “really existing market economy”, but mindsets are also important, as well as cultural influences exercised by domestic and foreign opinion makers.

Now at first, right after the collapse of the planned economy, this mixture of opinion shaping factors created a surprisingly “pro-business” view, bordering on libertarianism. Isn’t it strange, given the antecedents? Well, the Marxist, quite deterministic, view of the world included a mental model of “base and superstructure”: the former consisting of economic relations, production structures, and technology, while the latter covered values, ideas, political and social institutions. The former is supposed to determine the latter (dominance of the “mode of production”) even if some reformist ideologues allowed for interrelations; still the classical Marxist creed claims that the influence of the base predominates. According to this hypothesis, business community must be the predominant institution vis-à-vis the state in developed “capitalist” societies – in total contrast to a Socialist-Communist state where under the pretext of “organized labour” the State, under the control by the one and only party, takes the commanding position in every aspect of life, the economy included.

You may claim that there were rather few Marxist believers left at the time of the political regime change; still old dogmas lingered on for a while. When it comes to ideas and values, one should always take into account the nature (Marxist) and standards (low) of social education in former Communist countries, which had long lasting effects in society.

If mechanistic Marxist doctrines supported an economy-centred view of modern society, so did the mainstream Western economics through their promoters (frequently converts to the new creed). The commonplace mainstream view on modern market economy is that business and politics are worlds apart; the former’s business is business while the latter is about popularity and electioneering.

In reality, most nations live in some variety of mixed economy: there is a sizable public sector alongside the privately owned business sector. The government is invariably a major market player: producer of products, chief service provider, the biggest employer, regular buyer of goods and services – civilian and military alike, in addition to being the representative of voters’ will. On top of that, the state also regulates, taxes, and supports the society and the economy down to the details.

If actual modern states fall far from their text-book definitions, so do business actors. The business sector of any major economy consists of a huge number of firms and economic organizations of various sizes, interests, and motives.

The interactions between the state and businesses are therefore complex and culture-determined, quite different from the sanitised mainstream model’s view of a market based (capitalist) society. The transition process evolving in the region after 1990 testified that public policies, including the state-business relations, have a crucial role in economic development and the management of the transition crisis. Similarly, the structure of the business sector (whether foreign owned or not, with or without viable state owned enterprises; with more or less dynamic small and medium sized firms) critically influences the adjustment processes during these hectic years. Thus there are ample proofs of the relevance of having a structured view of business–government relations, and of the significance of adequate state policies controlling and regulating the business sector. Still, it was the recent international financial crisis that changed the public perception of the whole complex of business, state, power, social responsibility, and politics.

In the Hungarian case this crisis period coincided with the end of eight years of Socialist-Liberal rule, leading to a new government in 2010. What happened in Hungary, and how the public looked at the events of the crisis can only be understood in the context shaped by previous developments. This is why we have to look back a bit into the history of Hungarian economic and political processes, and take stock of their legacies.

Big versus small, foreign versus domestic – Hungary’s businesses during the transformation process

It is well known that the present Hungarian economy is highly dependent on foreign trade and finance. Economic openness has been its determining characteristic since the very start of the systemic transformation. Level of openness is not always a question of policy choice: in this case, the present situation is vastly determined by the path leading to the regime change. The newly born democratic Hungary inherited in 1990 a huge amount of public debt that had been accumulated in earlier periods as one of the dire consequences of Communist mismanagement of the economy. The first democratically elected government of Prime Minister József Antall embarked on a dual task of managing the financial crisis and rebuilding the economy at the same time, hence its determined efforts to bring in foreign non-debt creating funds.

The region in the early 1990s was just about to appear on the radar screen of international investors, thus it took a lot of efforts to convince fund holders to invest in the Hungarian economy. The government measures included tax policies (offering generous tax holidays), creating a business-friendly environment by streamlining regulatory procedures; but perhaps the most powerful policy instrument was the use of the privatization process.

The Hungarian privatization practice included various techniques, with the notable exception of voucher-type distribution of property titles of the overgrown state sector: the main technique among those applied eventually was competitive sale of state assets for cash. This is the method that promises the highest budgetary income and proper transparency of the process.

The overall balance of such a policy was unquestionably positive: Hungary avoided sovereign default on the huge amount of inherited foreign debt, and industry modernization process took a very dynamic start. While this policy has been quite effective in dealing with the above dual challenge, the downside is that it cannot but favour cash rich foreign firms and transnational investment funds. This is why its indirect consequences are harder to classify as good or bad. Satisfied foreign buyers of state owned companies are likely to consider further investments opportunities in the Hungarian economy, whether taking part in other privatization deals or in the form of “greenfield” projects – which is good for an economy suffering from shortage of capital. What is of course problematic is that sudden high capital inflows may destroy less competitive incumbents. Foreigners’ hegemony in privatization may undermine initial public support for privatization as such, and for market reforms, in general, among citizens.

On the other hand, the growing presence of foreign players in the Hungarian economy since the early phase of transformation has had also indirect modernizing impact on the functioning of the state by accelerating the “Westernization” of government regulations.

Hungary as an investment target stood out among other economies of comparable size and level of development in the early and mid-1990s: this relatively small economy absorbed as much capital as the rest of the region put together (Slovakia, the Czech Republic, Poland, Romania). Lately, other investment target countries also successfully emerged; therefore the most recent Hungarian data on the relative share of foreign funds does not stand out. The World Investment Report, 2010 shows that the stock of FDI (as percentage of GDP) is about 50 per cent in Hungary, compared to the EU average of 35 per cent, or 40 per cent in Austria, 30 per cent in Poland, 50 per cent in the Czech Republic, and 50 plus in Slovakia.

Such an FDI-determined development path, however, lends itself to two different interpretations; the first is that the Hungarian economy (or the Slovak, for that matter) has been highly successful in absorbing foreign capital; the second, and more sceptical, reading of the facts is that domestic businesses have been unable to keep pace with the world. Foreign firms account for a quarter of Hungarian employment, a third of all pre-tax profit and two thirds of the exports. That also means that the rest of the economy, i.e. the domestic businesses, only accounts for a third of the exports. In some key fields the foreign presence is surprisingly high: in the financial sector the share of foreigners in banks’ equity amounts to 70 per cent, in manufacturing to 60 per cent. The share of foreign capital in wholesale and retail is about 40 per cent, while in tourism, agriculture and construction it is in the 5 to 20 per cent range.

Political cycles in dealing with foreign capital

It is obvious that big firms do have bargaining power vis-à-vis the governments, even if the power relations are very much determined by the particular economic and political conditions. Let us consider the very outset of the systemic transformation: investors looked upon Hungary as a promising emerging market that still carried certain business and political risks, therefore sponsors of big investment projects asked for government support (including subsidies) to offset those risks. Hungary not being yet an EU member, the government’s bargaining position was not strong. Consequently in the 1990s a couple of major corporations did receive generous tax reduction schemes; in some cases with a time span extending into the years of Hungary’s membership in the European Union. During the accession negotiations in 2002, the European Commission called for the termination of such investment support schemes, as they did not fit into the Community’s policies concerning “state aid”. A solution reached in December 2002 put a ceiling on the overall amount of tax concessions available for big foreign investors, thus meeting the demands of the EU, without an abrupt change of the tax regime under which these firms had come to Hungary. As a result, no such major firm terminated its core activity in Hungary.

Still, a few plants have been closed since Hungary’s accession. But relocations to the Far East have been motivated less by the ending of the generous tax regime than by an increasing wage level in Hungary and a real appreciation of the national currency. These factors resulted in an increase of unit labour costs in euro or dollar – a reason enough to move labour intensive, low value added production out of Hungary. At the same time, new sources of FDI have added to the stock of foreign holdings in Hungary. One significant, albeit underreported, component of foreign capital accumulation is reinvested profit. Since inflows into the Hungarian economy started rather early, a great number of foreign owned ventures entered their profitable life cycle around year 2000. Roughly half of their profits has been reinvested in the Hungarian economy rather than repatriated.

Society’s attitude to foreign investors had undergone major changes by the end of the first decade of transition. Public sentiments were influenced by the realization that the Hungarian economy came to be dominated by large (mostly foreign owned) firms while a high number of under-funded micro, small and medium sized enterprises (SME) struggled to survive under the new market conditions. Governments had been, naturally, aware of the fact that cash rich foreigners may sideline domestic players. PM Antall’s government sensed the dangers inherent in a privatization process, and it made great efforts to create the appropriate legal and financial conditions for local businesses. His government tried to balance the foreign/domestic composition of buyers in order to prevent the dominance of foreigners in the privatization process, and introduced specific support schemes for domestic small and medium firms (the so-called Existence Loan and Privatization Loan), and offered preferential treatment to domestic buyers in the first round of privatization. Over 200 companies were denationalized in early 1990s through Employee Stock Ownership Plans (ESOP) – also a technique supporting the local community.

These policies were, unfortunately, all discontinued when the Socialist-Free Democrat coalition took power in 1994. Advocating free market values and policies, an interesting phenomenon for a nominally Socialist government, this government rejected efforts to strengthen domestic entrepreneurs, and preferred instead selling national assets like the energy sector and water management to big foreign entities such as Electricité de France, RWE and E.ON. Big business had its best time with the Socialists – while public support for privatization, and the market economy, in general, melted fast in Hungary. In this four year period macroeconomic figures were rather improving, the Western press coverage was mostly positive, but these are the very years when market economy and a socio-economic system lost its shine for the citizen: corruption, social insensitivity and the exclusion of many from economic progress damaged social values and popular perceptions (see my previous piece in this Journal).

The election to office of the second non-Socialist government under PM Orbán in 1998 led to major changes in policies. The SME sector once again received direct budgetary support, while foreign owned firms had harder times in winning public sector bids than previously under the friendly Socialist-Free Democrat rule. The Orbán Cabinet launched a national development programme (the Széchenyi Plan) with the goal of supporting the domestic SME sector, and preparing it for the coming EU competition.

Unfortunately, this Plan was immediately suspended as soon as the Socialist-Free Democrat coalition returned to power in 2002. Accession to EU in 2004 changed the context: EU membership excludes direct state aid to domestic economic agents. But the EU rules do allow national policy measures to strengthen the SME sector. The Socialists, instead, introduced projects to promote business spillover between multinational firms and smaller domestic subcontractors – with very limited results. The problems of Hungary’s economic duality aggravated further during the Socialist rule. The international financial turbulence in the autumn of 2008 dramatically exposed the fragility of the Hungarian economy, so dependent on foreign financial and product markets.

Conclusions

Revisiting the antecedents helps the reader grasp the context of business–government relations in the Hungarian case. The history of transition proves that weakness of the domestic sector poses both political and economic problems: undercapitalized domestic firms are not productive and competitive enough, their employing capacity is limited, they cannot pay fair wages and do not contribute properly to the costs of running the state, due to their limited capacity (and willingness) to pay taxes. Foreign firms earn above-normal after tax profit, while they do not contribute much to job creation.

In such a dual economy, too many desperate citizens turn to the government for solutions to their problems. Dissatisfaction with the market economy intensifies as time goes on, and attitudes to capital, foreign or domestic, change for the worse. Foreign firms are vital for the economy as sources of funds and technology, and as export achievers, but the hoped for modernizing impact of big business turns out to be limited. What the Hungarian case clearly illustrates is that a low productivity domestic sector and a highly productive capital intensive foreign owned sector may coexist for a long time in a dual economy without much collaboration and linkage between the two.

Given these problems, it became obvious by 2010 that a policy correction was needed, even if EU membership limits the government’s choice of corrective measures. PM Orbán’s centre-right government immediately took unorthodox steps aiming at supporting Hungarian-owned small and medium-sized enterprises directly and indirectly, at the expense of high profitability sectors. As the preferential treatment of energy firm Hungarian Oil (MOL) or the state owned Hungarian Electricity Board (MVM) indicate, big domestic corporations may also get political support.

Foreign players, naturally, are unhappy with the policy climate change, even if executives realize that short term domestic political goals are driving some of these measures and harsh statements, such as the legally and politically sensitive issue of renegotiating earlier privatization contracts, as raised by leading personalities. It is easy to imagine that such messages bother international investors. Public statements by PM Orbán and his economics team have contained strong criticism of banking practice and of the activity of international financial institutions; the Prime Minister has recurrently denounced financial speculation in his policy speeches. It is telling that an often-repeated official statement blames the mandatory private pension funds for “putting people’s savings on the stock exchange” – as if risk taking on a stock exchange were a dubious practice to be absolutely avoided.

Obviously, the target of such policy messages is the Hungarian general public. Voters are being prepared to digest that costly welfare systems will soon undergo drastic changes. Part of the message is that even mighty businesses have to give up some of their former entitlements, and the burden is not all on the “man in the street”. Official speeches also underline the importance of hard work and tangible, productive activities – productive being defined in contrast with speculation. The government is proud of the major industrial investments such as those announced by German carmakers Opel, Audi, in particular of the single most important project of Mercedes-Benz in Kecskemét, where four thousand jobs will soon be created. A certain “reindustrialization” of the economic system is lurking in the policy statements; and whatever one thinks of its feasibility, this new policy line is in harmony with other measures aiming at creating a high number of tax paying jobs in the Hungarian economy.

If the job-creation policy works, and thus greatly broadens tax bases, Hungary can maintain a low tax system, to the benefit of businesses, small and big alike. This is how long term growth and fiscal sustainability of public finance can go together – a macroeconomic situation that the whole business sector would warmly welcome. We will see soon whether job creation policy initiatives work.

References:

Antalóczy, K. – Sass, M., “Greenfield FDI in Hungary: Are they Different from Privatisation?” Transnational Corporations, vol. 10, no. 3., December (2001).

Hunya, G., “International competitiveness impact of FDI in CEECs”. WIIW Research Report No. 268. August (2000).

UNCTAD World Investment Report, 2010, (2011).