Title page 1

Contents 6

Abstract / Résumé 5

Introduction and main findings 8

1. Structural features and limitations of Hungary's flat personal income tax (PIT) system 10

1.1. Work incentives are relatively low at the bottom of the income distribution 11

1.2. The redistributive impact of the PIT system has declined 13

1.3. PIT revenues are low, only weakly related to economic activity and projected to decline due to ageing 15

2. Towards a more progressive PIT schedule 18

2.1. PIT on labour income 18

2.2. PIT on capital income 20

3. Quantifying the impact on PIT revenues 22

3.1. Static impact of the PIT reform (Scenario 1) 22

3.2. Behavioural responses on PIT and SSC revenues 23

3.3. Impact of the PIT reform (Scenario 1) on other tax revenues 27

3.4. Impact of the PIT reform (Scenario 1) on tax buoyancy 28

3.5. Impact of the PIT reform (Scenario 1) on capital income taxation 29

3.6. Total impact of the PIT reform (Scenario 1) on tax revenues 31

3.7. Total impact of the PIT reform (Scenarios 2 and 3) on tax revenues 32

4. Impact of the PIT reform on potential GDP 34

5. Impact on income inequality 36

6. Political feasibility and optimal tax rates 38

6.1. Political feasibility 38

6.2. Distance to optimal tax rates 38

Conclusion 40

References 42

Annexe A. Quantifying the impact of a PIT reform on tax revenue, accounting for behavioural responses along the intensive margin 48

Annexe B. Heterogeneity in labour supply elasticities 51

Annexe C. Political feasibility and sufficient statistics for optimal tax rates 52

Table 1. Current and proposed PIT schedules on labour income 18

Table 2. Measurement of the employment effect, by decile of the income distribution 24

Table 3. Impact of the reform (Scenario 1) on PIT and SSC revenues: substitution effect 25

Table 4. Impact of the reform (Scenario 1) on PIT and SSC revenues: income effect 26

Table 5. Impact of tax buoyancy on tax revenues 28

Table 6. Impact of the PIT reform (Scenario 1) on capital income: two scenarios 29

Table 7. Total impact of the PIT reform (Scenario 1) on tax revenues - Sensitivity analysis 32

Table 8. Impact of the PIT reform (Scenarios 2 and 3) on tax revenues 33

Table 9. Impact of PIT reforms on income inequality 36

Table 10. Optimal top PIT rate under alternative assumptions 39

Table 11. Estimated elasticities of taxable income in the academic literature 50

Figure 1. The tax wedge for low-income workers is relatively high for singles 12

Figure 2. The tax wedge for low-income workers is relatively high for couples 12

Figure 3. The average income tax rate for low-income earners is one of the highest in the OECD, while the top marginal tax rate is one of the lowest 13

Figure 4. The redistributive impact of the Hungarian tax system is relatively low 14

Figure 5. Tax progressivity is the lowest among OECD countries 15

Figure 6. PIT revenue decreased due to tax reforms 16

Figure 7. The effective average tax rate gap between pensioners and workers is large 17

Figure 8. Population ageing will weigh on the tax-to-GDP ratio 17

Figure 9. Effective marginal and average tax rates on labour income for different PIT schedules 19

Figure 10. Top marginal income tax rates would remain relatively low in all scenarios 20

Figure 11. Labour income is taxed at a higher rate than capital income in Hungary 21

Figure 12. Most Hungarian taxpayers would gain from the PIT reform (Scenario 1) 22

Figure 13. The saving rate is particularly low for low-income households in Hungary 27

Figure 14. The PIT reform will support potential GDP 34

Boxes 7

Box 1. Quantifying the impact of a capital income tax reform, accounting for behavioural responses 30

Box 2. Potential GDP and the OECD long term model 35

Box 3. Quantifying the impact of the PIT reform on inequality 37