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By Dr. Laszlo Kallay
Institute for Small Business Development, Hungary
In the late eighties, Hungary started a transition process
from central planning and a soft communist dictatorship towards
a free market economy and political democracy. On the ruins
of the old economic regime hundreds of thousands of new businesses
emerged in a country of 10 million people. With the legacy
of an informal sector in the planned economy, one of the major
concerns of economists and social scientists was that the
informal sector would grow tremendously.
New institutions, new entrepreneurs
In the early phase of transition, entry barriers (costs of
registering a business) were low. Registered businesses could
deduct business expenses from their taxable income, and sometimes
enjoyed tax benefits as well. As early as 1989, the Hungarian
government started a deregulation campaign abandoning several
pieces of regulation. The economy was liberalized relatively
fast; several restrictions (on, for example, establishing
a business, accessing information or travelling abroad) and
state control over foreign trade, currency issues, licensing,
investment and employment were renounced. During this time,
enforcement efforts of the government were not particularly
intense. Hence, the majority of small and medium-sized enterprises
(SMEs) could follow a minimum taxation strategy, meaning they
did not pay profit or income taxes and kept social insurance
contribution payments at the lowest possible level. This led
to a gap between the amount of taxes to be paid by law and
the amount actually paid. In short, the major form of informality
during this phase of the transition was tax evasion by registered
businesses. Interestingly, even at the beginning of the transition
process, the benefits of having a registered business outweighed
the costs of registering and operating a business.
What happened next challenges the simple interpretation of
the role of transaction costs. Transaction costs of registering
and operating a business (including money, time and effort)
slowly, but surely started to increase for two reasons, a)
regulation on licensing became more extensive; b) enforcement
of income tax collection became more intensive. This means
that although, generally speaking, tax rates were somewhat
lower, taxes and contributions were paid on a higher proportion
of income. At the same time, most of the estimates indicated
that the share of the informal sector in the Hungarian economy
decreased in this period. Other signs such as the number and
quality of tax returns, and fewer cases of non-payment problems
also supported this finding. At first sight, this seems to
be a contradiction. Higher transaction costs and lower share
of informal sector?
One potential way to address this contradiction is if we
think about transaction costs in relative terms, and not as
amounts of time and money derived from what the rules say.
The key notion is the learning process. If entrepreneurs learn
to comply with the existing rules, the actual level of effort
may be lower even if obligations prescribed are more complicated.
Chart 1 shows, SMEs in Hungary felt somewhat less uncomfortable
about high levies and unexpected changes in regulation as
an obstacle of doing business in November 1999, than two years
before. In the same period, competition became a more important
challenge for them. As a result, entrepreneurs spent more
effort struggling for markets, and less effort evading taxes.
Paying taxes and social contributions at high rates is one
of the major costs of doing business for the ventures in the
formal sector. So one of the key elements of making formality
more attractive is to reduce the role of income redistribution
systems that are funded from taxes and social contributions.
This happened in Hungary from the mid-nineties (see Chart
2). The reason for this is not only the lower level of
income centralization and a more stable legal and regulatory
environment, but more importantly the improved capacity of
SMEs to comply with the rules.
Chart 1
Intensity* of Obstacles of Doing Business in Hungary
Source: Business survey data by the Institute for Small Business
Development
*Calculation of the intensity indicator: the respondents
appraised the importance of the factor on a scale of five
grades, ranging from 0 to 4. The each grade was multiplied
by the number of respondents, who chose it and divided by
the possible maximum value of the given indicator. This resulted
in a percentage value, the maximum of which is 100 (if each
respondent assigned the maximum importance to the given factor)
and the minimum of which is 0 if (if everyone attached the
least importance to it).
Taxation is always one of the most problematic issues for
SMEs. More than 70% of businesses in Hungary (including one
person units) contract out accounting. As a result, there
is an abundant supply of these services at affordable and
reasonable price-quality ratios. For the majority of businesses,
complying with the rules of taxation and paying social contributions
involves simply consulting with the accounting firm they contracted
with. This not only keeps the cost of compliance low, but
also reduces the risk of additional expenses arising from
non-compliance such as fines for tax return errors and omissions.
Having the capacity to comply with regulations at a reasonable
cost is important in an emerging market economy where regulations
tend to become increasingly sophisticated over time. Central
and East European countries, for example, have to adopt a
huge amount of European Union regulation in the course of
the accession process, so improving capacity to comply with
the rules may result in lower actual transaction costs.
Chart 2
The Degree of Income Centralization and Redistribution in
Hungary, 1990-2000
Source: Official budget statistics
The degree of income centralization = all revenues collected
by the central budget, local governments and the state social
security system/GDP
The degree of income redistribution = all spending
by the central budget, local governments and the state social
security system/GDP
The Role of the Government Policy: An Unintentional Strategy?
Although the Hungarian government declared only its intention,
but never a comprehensive strategy to reduce the size of the
informal sector and attract more activity to the formal one,
government and parliamentary actions seem to have contributed
to a smaller informal sector. The key factors included lowering
registration costs at the beginning of the transition process
by providing the opportunity to deduct costs from the tax
base and by compensating for high tax rates by not rigorously
collecting taxes. Later on, when the early transition crisis
was over, the economy began to grow, and the number of registered
businesses stabilized, the government sent signals to small
businesses indicating what was the expected level of (declared)
income in different trades and professions. Most of the entrepreneurs
got the message and reported income earnings just above the
expected level. The result was a gradual increase in the proportion
of formally declared income. An other element of this strategy
was that the level of minimal payment (mainly social security
contributions) was raised annually.
How can governments be motivated to reduce the degree of
income centralization which is a key element of any transaction
cost reducing strategy? Hungary has had three different governing
coalitions since the first democratic elections in 1990. All
of them felt pressure from different communities of the society
to reduce levies, leave more income at production entities.
This resulted in political parties engaging in a bidding process
over reducing income centralization. This competition became
incredibly intense during election campaigns and indicated
that it is easier to minimize government involvement in the
economy if this is a widely shared, societal value.
Comparison of Two Stages
The history of the transition process from the point of view
of informal economic activity in Hungary can be divided into
two stages. The behavior of entrepreneurs, the governmental
policies, and the state of the whole economy differed in each
of the two stages. The following table is a summary of the
most important aspects and changes.
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