Hungarian Prime Minister Viktor Orban has pledged to slash the corporate tax rate to single digits in 2017, as part of an agreement with business on October 24 to increase minimum wages by 15% next year. 

Such a huge cut to the headline corporate tax from 19% could turn Hungary into the tax haven of Central Europe. However, as other business costs remain elevated and the country struggles with a serious shortage of skilled labour, the tax cut might not be enough to significantly boost Hungary's competitiveness and FDI inflow.

As part of its fiscal adjustment strategy, the ruling Fidesz party has imposed special taxes that have mostly hit international investors. Since 2010, foreign media companies, retailers, energy suppliers and tobacco sellers have complained of discrimination, hurting the country's investment reputation.

In 2016, Hungary scored an all-time low and became a the sharpest slider in Central and Eastern Europe in the Global Competitiveness Index (GCI) 2016-2017, mainly due to institutional weakness, including a lack of transparency in government policymaking and advantages handed to “privileged businesses”. Meanwhile, net foreign direct investment (FDI) has decreased, reaching a record low of -€15.37bn in the last three months of 2015, and staying negative all this year so far, pushed down by high dividends and repayment of loans by foreign-owned companies.

The government now seems determined to step up efforts to improve its international ranking and lure back foreign investors to the country. Some analysts argue that the earlier turbulent times are over, and the huge reduction of corporate tax – coupled with a decrease of employer social security contributions – suggest that the government aims to begin a new era of consolidation by creating a friendly tax environment.

“The corporate tax reduction is a good message, it strengthens the country’s ability to raise capital and investment,” Economy Minister Mihaly Varga told MTI.  

Hungary's corporate tax system currently has two rates, 19% for those with revenue above HUF500mn (€1.6mn) and 10% for smaller companies. The new single-digit rate will apply to both SMEs and large corporations. It will be the lowest level in the EU, and by far the lower in the region (compared to 19% in the Czech Republic and Poland and 21% in Slovakia).

The reduction of the headline corporate tax rate in Hungary will certainly be welcomed by foreign companies. “We have been advocating for a long time that CIT [corporate income tax] should be gradually decreased in Hungary to a flat 10% to improve our investment climate and thus our regional and global competitiveness,” Ferenc Pongracz, president of AmCham Hungary, a business chamber representing the interest of 368 international investors, including the largest US companies in Hungary, tells bne IntelliNews.

AmCham Hungary expects that investment from US companies will grow as the result of the corporate tax reduction. "We believe this [corporate tax reduction] is a key factor besides availability of skilled workforce, a stable and predictable regulatory environment, among others,” Pongracz tells bne IntelliNews.

However, only the largest domestic businesses will benefit significantly from the tax reduction. SMEs – which are currently subject to a 10% rate – are unlikely to feel a big difference due to a 1pp cut, while tax rates for large foreign companies are already significantly reduced by subsidies and tax concessions. German carmaker Audi, for example, did not pay any corporate tax in 2015, as it benefitted from R&D tax allowances. Wizz Air, Suzuki, GE, Mercedes and Bosch paid 1-2% corporate tax, while South Korean electronics producer Samsung was the only one out of the top 10 revenue companies in Hungary whose corporate tax payment (15.9%) was close to the headline corporate tax rate.

At the same time, companies are subject to a series of other expenses that remain elevated in Hungary, such as the 2% local business tax and the 27% VAT, which is the highest in the EU. Hungary also had the fourth highest tax wedge on labour (49%) among the 34 OECD member countries in 2015. Even with the government’s multi-year contribution reduction programme – aimed to be completed by 2022 – Hungary’s tax wedge would remain the highest in the region.

According to the latest report of the European Commission, in 2015 Hungary was the only country in the Visegrad group where the effective tax rates for companies – the percentage of income actually paid in taxes – was higher (19.3%) than the headline corporate tax rate. In Slovakia, the effective average tax rate was 19.6%, while Polish and Czech companies paid 17.5% and 16.7% (respectively) of their profits in taxes.

Hungary’s corporate tax reduction might nevertheless trigger cuts in other Visegrad countries, creating a 'race to the bottom'. “Given that these countries aggressively compete with Hungary to win auto investment contracts, there is a high chance that they will begin offering similar tax incentives to remain a competitive location for foreign direct investment,” BMI Research wrote in a note. The Slovakian parliament already took the first step as it approved to reduce the country's corporate tax rate from 22% to 21% on November 23.

Analysts also warn that the huge corporate tax reduction might attract companies that aim to reduce their tax burden by profit shifting, without actually increasing business activity. 

As Hungary currently faces a serious shortage of skilled labour, many argue that significantly boosting competitiveness is impossible without improving the country’s education system. Critics fear, however, that the tax cuts will add to pressure on the budget, reducing the possibility of spending on structural reforms and improving education, or even on basic social services and healthcare.  

The government nevertheless insists that impressive budget surplus figures leave room for manoeuvre and hopes that the expected HUF145bn (€468.6mn) of corporate tax revenue decline will eventually be neutralized by increased investment that will boost the counrty's GDP growth.

The reduction of the corporate tax would "create the groundwork for lifting economic growth from the current rate of 2-3% per year to 3-5%," Varga told MTI. He added that the ministry has already “received inquiries from Canada” to confirm whether the news about Hungary's tax reduction are true.