Rethinking the economy after Covid: How can Hungary be more competitive?

Investing in people, public services and the business environment (including, crucially digital infrastructure) are appealing ways to achieve longer-term growth through making Hungarians and the Hungarian economy more productive. These types of policies respond to the challenges that were highlighted by the pandemic and can be helpful during the recovery but have the potential to spur further economic growth, writes Daniel Prinz. 

By Dániel Prinz, Harvard University and András Radnóti, Millennium Emerging Europe

Covid has hit the Hungarian economy hard. During the second and third quarters of 2020, Hungary’s economic performance was the weakest among the V4 economies. This was at least partially a consequence of the government’s weak fiscal response to the crisis. The government was very concerned about providing sufficient fiscal stimulus at the cost of high deficit and rising public debt. But at the end, Hungary ended up with high deficits and skyrocketing public debt on top of a deeper-than-necessary recession, limiting the government’s ability to spend going forward.

In addition to the lack of appropriate fiscal stimulus, the Covid crisis also revealed deeper problems of the Hungarian economy. Companies, workers, and public services (including healthcare and education) were simply not ready for the transition to a stay-at-home, largely digital economy. Crucial public services and supports were missing during the crisis: citizens were not provided clear, reliable, and readily available information on the nature of the pandemic, students and parents were lost in a dysfunctional and lacking online education system, companies trying to save jobs using the government’s Kurzarbeit program were facing heavy administrative burdens. Even at the end of 2020, after almost a year of the pandemic, schools are lagging behind in offering proper online classes, getting a Covid test involves a large amount of paperwork (on actual paper), and government agencies do not allow their employees to work from home.

During 2021, the government will face limited fiscal space while trying to rebuild the economy. The key challenge will be to rebuild while increasing competitiveness, making Hungary more productive and generating more rapid growth. Priorities for the government should be investing in people, public services, and improving the business environment, including digital infrastructure.

Investing in people. High-skill workers weathered the Covid crisis (and other crises before) the best. More educated workers are more able to adapt to changing circumstances, including working from home, and are generally much more employable (for example, pre-crisis, the unemployment rate was 1.7% for university-educated Hungarians and 3.4% for those who only completed high school). This suggests that investing in human capital will make Hungary more resilient during crises and during the post-Covid economic transformation. The government has also realized this to some extent: after years of rhetoric suggesting that there are too many college-educated workers and not enough with vocational training, during the Spring lockdown, they made it easier to obtain university degrees and invested in online training for IT jobs. But by the end of the year, it appears that these were more short-term policies designed to signal that the government was doing something, rather than longer-term shifts in policy.

Policy makers would do well to recognize that the only realistic source of sustainable longer-term growth is increasing worker productivity. Hungarian workers are the least productive in the V4 region and Hungary’s productivity improvements have lagged behind those of its regional partners during the last decade. There are a number of specific examples of policies the government could adopt to invest in people and skills:

• Encourage rather than discourage university attendance. The government’s rhetoric has been that too many people attend university, while not enough people have vocational training. This is contrary to empirical evidence: in fact Hungary has consistently had the highest university wage premium in the region (indeed, in the whole OECD, except for Brazil) and unemployment is virtually non-existent for university graduates (and has been half to one-fourth of the unemployment rate for those with a vocational training over the last decade).
• Encourage rather than discourage the completion of the academic high school track. In addition to discouraging university attendance the government has also cut back access to academic-track high schools. This means that fewer Hungarian students graduate with strong foundations for further education and skills that make them adaptable learners, a key to succeeding in evolving labor markets.
• Redesign the curriculum for vocational high schools to help students acquire more general skills. In addition to discouraging students from attending academic-track high schools, the government’s policy has also made vocational high schools more focused on specific vocational skills and less focused on general education. This is a mistake because it hurts student achievement, locks the students on this track into specific occupations, makes them less adaptable, and ultimately less productive and competitive.
• Move the compulsory schooling age back from 16 to 18. Decreasing the compulsory schooling age, going against international trends, was a clear mistake. It has increased the number of youth who are neither in employment nor in education or training (NEET youth) without any detectable boost to employment. The government should move the compulsory school age back to 18 and invest in forms of education that would allow disadvantaged youth to develop human capital instead of dropping out early.
• Focus on skill development at all levels. The government has taken steps that make the education system less competitive at all levels, emphasizing factual knowledge over key skills. For example, while the government apparently recognizes that increasing employment in the IT sector is key to competitiveness, they have reduced training in these skills at the secondary level. Hungarian workers, regardless of whether they have secondary or tertiary education should be equipped with basic skills such as IT, foreign languages, critical thinking, communication, and the ability to constantly learn. Empirical evidence suggests that these skills command a wage premium even in jobs that require only a high school education.

Investing in public services. The crisis underlined that Hungary needs to drastically improve its public services on many fronts, including healthcare, education, and social care. These are fundamental to welfare directly but also to economic competitiveness indirectly. During the crisis, the healthcare system failed Hungarians: in many hospitals chaos ensued, the government ordered the emptying of many institutions to receive Covid patients (who never materialized), testing levels were lower than in other countries in the region, while more people died. The education system was unable to deliver digitally. The government did not provide disadvantaged youth (or anyone for that matter) with necessary devices or even basic software, many teachers were unable or unwilling to teach proper online classes. During the second wave, the failures of the first wave were repeated. The disruption to education will hurt students in the longer term, making Hungarians less productive. It is not shocking that Hungary’s healthcare and education system could not deliver: public spending on both sectors has been low and lagging behind other countries in the region. Hungarian teachers and nurses are chronically underpaid, leading to shortages of critical personnel and crowding.

Going forward, policy makers should invest in accessible public services which are key to competitiveness and inclusive growth. Some specific examples of policies that the government should consider:

• Invest heavily in the humans delivering public services. The government has invested heavily in physical infrastructure in many areas, but has failed to invest in human capital. While many new hospitals have been constructed using EU funds, the healthcare system is chronically understaffed and nurses are underpaid. While there has been investment in school buildings, there is a massive shortage of teachers and the selection of high-skilled teachers who can substantially improve student outcomes has not improved. The government should invest in human capital and delivery of high-quality, personalized services.
• Integrate human service provision. Complex problems require complex solutions. Families in disadvantaged communities need help with healthcare, education, finding work, child care, and on other fronts. Elderly citizens often need help with their daily life, healthcare, financial planning, and transportation. The government should accordingly invest in integrated human services agencies that can address the challenges faced by citizens holistically, rather than providing one-off programs.
• Increase rather than decrease funding to local governments. While municipalities were already in a difficult fiscal position because of crisis-driven revenue losses and additional costs, over the last months, the government has taken several steps that further complicated municipal finances. They have passed rules that limit local governments’ ability to levy local taxes at a higher level and cut some local taxes that were key revenue sources. This is a mistake during a pandemic when municipalities are at the frontlines of dealing with the crisis, as well as providing social care, primary healthcare, early childhood education. The government should ensure that they receive extra funding that allows them to deliver these services and even increase their support capacity.
• Refocus tax and transfer policies to promote inclusive growth. Over the last decade, tax and transfer policies have shifted in a regressive direction, including the introduction of flat rate income tax, family taxation and direct subsidies and subsidized credit lines for homeownership. Even during the crisis, the government has added new subsidy programs that favor higher-income families. Recalibrating these policies to help disadvantaged families (e.g., drastically increasing income support programs) and lower-income workers (e.g., introducing a working tax credit) would lead to a more equal distribution of recent gains from economic growth and more broad-based convergence.

Improving the business environment. The crisis highlighted that Hungary's digital infrastructure (including in public services, healthcare, and education) is weak. More investment in this area will make Hungary more competitive directly, but also indirectly by supporting companies in the digital space. But investing in digital infrastructure is just one example of broader policies that aim to improve the business environment (Hungary is the weakest overall in the V4 region) in a sector-neutral, broad-based way. Other policies could include reducing red tape, removing unnecessary regulations, as well as rescinding sector-specific distortionary tax policies (including both extra taxes and tax breaks). These types of policies have the potential to increase competitiveness, helping Hungarian businesses grow and attracting foreign businesses without either the “race-to-the-bottom” competition that the government has been involved in (e.g., giving enormous tax breaks to a few foreign companies) or policies that distort competition and investment (e.g., sector-specific taxes on foreign banks). Some policies that the government could consider going forward:

• Make the government truly digital. While some effort has been undertaken to offer digital access to government services (including access to administrative services and health data), most of these initiatives are poorly designed or rather completely lack design thinking and are rather user-unfriendly. But beyond digital access, the government lags behind on digitizing its own operations: central government agencies and local governments are still largely paper-based, one of the reasons why during the pandemic home office was not an option for government workers while their counterparts in the private sector transitioned much more easily. The government should work closely with major players in the industry to digitize its services with state-of-the-art, well-designed solutions. (After all, one of the most important players in the cloud space is LogMeIn, founded in Budapest.)
• Eliminate distortionary taxes and subsidies. The government’s policies have been distorting competition along a number of margins. Sector-specific taxes on banks and earlier taxes on food retail (as well as other threats against these businesses), advertisement taxes, and other similar policies make the economy less competitive because of cross-sector and domestic vs foreign distortions, but also because of decreasing business confidence and potentially investments. Giving tax breaks to certain foreign investors (e.g., auto manufacturers) does the same: trying to attract investment via tax competition raises concerns about sustainability and the ability of these companies to add value in the longer term.
• Remove unnecessary regulations and red tape. Instead of tax breaks and special interest investment programs, the government should aim to attract investment through investment in human capital and services (discussed above) and the elimination of burdensome regulations and red tape. From financial services to starting a business Hungary is lagging behind. Improving on this front is key to sustainable longer-term growth because it is sector-neutral and does not create the types of distortions that many government programs that favor various industries or nationals of various countries do.

Investing in people, public services and the business environment (including, crucially digital infrastructure) are appealing ways to achieve longer-term growth through making Hungarians and the Hungarian economy more productive. These types of policies respond to the challenges that were highlighted by the pandemic and can be helpful during the recovery but have the potential to spur further economic growth. At a time when fiscal space is limited, yet the longer-term health of the public finances will require more rapid growth, most of these policies are relatively cheap---especially when compared to the enormous sums the government has been mobilizing to prop up certain industries.