Europe: Hungary for growth By Gregory Fossedal Copyright © United Press International July 1, 2005 Link to this story at The Washington Times NEW YORK — His counterparts in much of Europe seem to be sleeping through the wake-up call, but Hungarian Prime Minister Ferenc Gyurcsany appears to be up and listening. Even as the rest of the continent wrangles over slow growth, EU budget divisions, and the rejection of the EU's constitution, Mr. Gyurcsany is taking action with a proposal for a substantial cut in tax rates. If he sticks with this plan, Gyurcsany will not only help continue Hungary's recovery. He may also provide a winning economic example, and a badly-needed political escape hatch, for Europe's leaders. "My kind of socialist" Here's what Gyurcsany has put on the table: — cut the country's top personal income tax rate to 36 percent from 38 percent, along with doubling the income at which the top rate begins to apply. — crop the top rate for the value-added to 20 percent from 25 percent. — perhaps most important, slash the profit ("corporate income") tax for small and medium businesses, and the Social Security tax, by about one-third. This last item is especially important. Like the U.S. Social Security tax, Hungary's social tax is "paid by employers." What this means is, regardless of who writes the check, it's borne by workers and consumers and employers together -- and reduces incentives for job creation, especially by major firms. (Hungary's social contribution, like the U.S. Social Security program, covers more than just pensions; unlike America's, it also covers certain health-care and other benefits. It is analagous to FICA plus the Medicare-Medicaid contributions, but hardly identical.) All this might sound unusual for the leader of the country's Socialist Party. Well, Gyurcsany, as a Bank of America debt trader put it, is "my kind of socialist." And, a review of the record shows, not merely a tax-cutter under duress — Gyurcsany's job approval ratings are down in the high 20s — but one with some conviction, and depth, on the issue. Europe's black (and blue) economy Gyurcsany's speeches on taxes and growth make the case. Whereas many developing-country and even Western-European analysts moan about the impossibility of cutting tax rates given the high degree of corruption and tax avoidance in their economy, Gyurscany sees a causal connection, and a solution that flows therefrom. As the Budapest Sun noted in a June 2 profile: "Acknolwledging that personal income tax in Hungary is high, Gyurcsany says that a tax cut would be the basis 'for growth based on individual performance....' "His government has 'taken substantial steps to reduce taxes,' and he promises further cuts as part of the Hundred Steps Program. Cuts are to be funded by 'measures to combat the grey and black economy' and by 'transforming state expenditures' for greater efficiency." Here at Bottom Line, we call this realization — as former communists and socialists come to grips with the black market — the "Putin moment." It was precisely at such a time, after years of Russian tax rates in the 70-80 percent range (when Social Security payments are counted), and amidst a credit and currency collapse, that Russia launched its flat-tax reform, taking the top tax rate to below 15 percent. "We need to cut tax rates not in spite of the black economy," as Putin put it in the spring of 2000, "but precisely because of it." The result? A quadrupling of government revenues (abetted by oil, to be sure), and an order-of-magnitude increase in stock prices — the Moscow Times index growing more than 1000 percent, low to high, over five years. Gyurcsany's guts Hungary's capable leader has also shown intestinal fortitude in both the economic and political fight over taxes. On the budget side, Hungary does face deficit pressures. In 2004, Hungary’s fiscal deficit was 5.3 per cent of the country’s Gross Domestic Product. The European Central Bank has set a fiscal deficit limit of 3.0 per cent to allow countries to adopt the single European currency. Unlike many in his own parliament, not to mention France and Germany, however, Gyurcsany seems to grasp that if solving stagflation with high deficits is difficult, sovling deficits with stagflation is impossible. He proposes to cut taxes to spur growth, but at the same time cut spending to help deal with deficit concerns. He's also supported recent policy moves by the Hungarian Fed, which this week joined some of Europe's smaller, outside-the-Eurozone banks (such as Sweden's) in reducing interest rates. Although Europe's growth problems lie mainly on the fiscal and tax rate side — especially in France and Germany — there's no doubt that a continuation of low rates and a soft currency may help on the margin to revive the moribund European consumer, and thus, do a little something to improve growth. On the political side, Gyurcsany has two ears, and some guts — all of them scarce commodities in the Euro-area these days. This week, even as his government put together finishing touches in its tax cut proposals, Bureausselcrats warned Gyurcsany condescendingly that his ideas might cause delays in Hungary's 2008 full EU entry. "I was surprised," EU Economic and Monetary Affairs Commissioner Joaquin Almunia sniffed haughtily on June 29, "when I listened to some new information talking about an announcement of new tax reform." Maybe so, but Gyurcsany aides went right ahead and began briefing members of parliament and the press on background on the tax proposal, as planned, on June 30. A leading opposition member of parliament (of the center right) told me this week, "Gyurcsany really gets it on tax rates. He could still back off if the pressure keeps up from Brussels, but so far it seems like they plan to go ahead" with tax reduction. Europe's conundrum It is less than five weeks since voters in France and the Netherlands soundly rejected entry into the European Union. There were many reasons, from the lack of direct democracy for the full EU as a check on the Brussels bureaucrats, to the almost anit-religious tone of the the union's constitutional draft. But most observers agree that sluggish employment in the EU outside of Britain and Eastern Europe, and the high tax rates and tight money that are causing it, were a major cause. Gyurcsany, along with Britain's Tony Blair, appears to have heard this message first. He may not, indeed, be alone. In Germany, the head of a major business group has called for substantial tax cuts heading into this fall's election — and stressed the urgency of the matter. Gerhard Schroeder, wisely, senses the electorate's angst, and has shrewedly moved up the date at which the electorate can issue a mandate on his term, rather than playing for time. Next week, Schroeder's party plans to release a manifesto calling for, among other things, a substantial tax rate cut for small businesses. Could it be that the states of Central and Eastern Europe, not so long ago considered a drag on Old Europe, will be a force for revival and renewal? Gyurcsany appears to have just that in mind. Hungary's "profound knowledge of the region," he remarked this month, is a potential asset for Western Europe in dealing with the South and East — as well as a model for spurring growth in France, Germany, and the no-growth, zero-fertility West. Bottom line Europe's political mess is still in the post-mortem and messy-shakeout phase. In the weeks after France and the Netherlands rejected the EU constitution, Jacques Chirac aggressively opposed needed reductions in French agrisubsidies, and appointed as his new prime minister one of the most elitist, anti-liberalization politicians on the continent. Italy has flirted with leaving the currency union. "When Italy questions your currency's strength," as a Swiss portfolio manager put it, "you know you are in trouble." Accordingly, the best strategy for European investments is balanced and hedged, as follows: Currency — We're still short the Euro, which especially reflects the political equation, and should have another last bear run in it, possibly as far as 1.1 to the dollar. Stocks — Still, pamplisets of freedom are emerging which may be positive for equities. In combination with the currency position suggested above, Central and Eastern European equities remain a buy, especially in the energy sector. And given the confusion at the center, it may actually easier for individual countries (Hungary, Britain) to adopt pro-growth fiscal policies on their own. Our clients remain long the Ukraine, Hungary, Poland, Ireland, the Baltic States, and Turkey. In many cases, questionable EU status is actually a positive. Even Germany may soon be a buy if the competition for growth policies heats up heading into this fall's election. France — probably still a short, especially since Chirac will be hanging around until 2007. We would buy if and only if the sick man of Europe, France's president, does the right thing and resigns. But don't count on it. Chirac has all of the arrogance of Charles de Gaulle, but with little of de Gaulle's greatness to back it up. Many difficulties remain for Europe, economically and, more so, on the poorly-managed political matter of how to create a true continental democracy. But when the history of Europe is written, it may well mark June, and the comeback of Hungary's Mr. Gyurcsany, as a key turning point. Gregory Fossedal, foss@upi.com, is an advisor to international investors on global markets and ideopolitical risk, and a research fellow at the Alexis de Tocqueville Institution. Mr. Fossedal's opinions are entirely his own, and are not necessarily those of his clients, UPI, or AdTI. Furthermore, they are subject to change without notice.