Taxing Capital Income in Hungary and the European Union

Abstract

Without higher savings rates, Hungary cannot expect accelerated economic growth. In reforming Hungary`s system of taxing capital income, policymakers should strive to level the playing field in financial markets but should not distort incentives to increase savings. Countries seeking membership in the European Union (EU) cannot look to the EU for a blueprint for reforming their system for taxing capital income. Indeed, it is hard to generalize about tax systems in the EU. Most member states apply fairly low tax rates to interest payments and discriminate against profit distributions. But tax rates, exemption levels, and methods of tax integration differ greatly within and across countries, and there is almost no harmonization of methods for taxing capital income. Approaches to taxing capital gains vary greatly, and distortions arise from the treatment of various sources of capital income. In 1993, when the EU began efforts to integrate capital markets, member countries proposed various ways to harmonize capital income taxes, including a proposal to introduce a withholding tax on interest income of residents of member states, with a minimum rate of 15 percent (revised to 10 percent). Under this scheme all interest on bank deposits and government and private bonds would be taxed and there might also be a final withholding tax on residents' Interest income. But the proposal was not accepted and the EU Commission decided to maintain the status quo, not to pressure member countries to harmonize company taxes. But Hungary could look for models in the Nordic countries (especially Norway and Sweden), Austria, and Finland, which have undertaken far-reaching reforms of capital income taxation. In most EU countries capital gains are either not (directly) taxed or are not taxed systematically. In Finland and Norway identical tax rates are applied to all types of capital income, including capital gains. The centerpiece of the Scandinavian model is a dual income tax, combining a progressive tax on personal income with a flat-rate tax on all types of capital income. The Scandinavian model contrasts sharply with the comprehensive income taxation model, under which a single (progressive) tax schedule is applied to income from all sources. In Austria the treatment of different types of capital income is relatively uniform but the composite tax burden on capital income resembles the highest personal income tax rate rather than a reduced rate. Austria's rate of tax evasion was high, but a 10 percent withholding tax applied to all interest-bearing assets has reduced discrimination against honest taxpayers. This paper - a product of the Poverty Reduction and Economic Management Sector Unit, Europe and Central Asia - is part of a larger effort in the region to research issues related to the European Union`s accession of Central and Eastern European countries.