Earnings Manipulation and Formalization Under Hungary’s Maternity Benefit System

This study examines how Hungary's maternity benefit reforms influenced earnings reporting and employment behaviors, particularly in small firms prone to tax evasion. The findings reveal that linking benefits to contributions incentivizes formalization but poses challenges in ensuring equity and redistributive fairness.

This research, conducted by Anikó Bíró and Péter Elek from the HUN-REN Centre for Economic and Regional Studies, Dániel Prinz of the World Bank, and László Sándor from the Consumer Financial Protection Bureau, investigates the interplay between tax evasion and maternity benefits in Hungary. By examining changes in earnings reporting and employment behaviors driven by the country's social security reforms, the study sheds light on how linking benefits to contributions incentivizes formalization while exposing vulnerabilities in such systems. With a focus on the 2015 policy reform that shortened the maternity benefit reference period, the study provides an in-depth look at how employers and employees respond to such changes, particularly in smaller, less-productive firms.

Strategic Adjustments in Earnings Reporting

The Hungarian maternity benefit system ties benefit amounts to earnings reported in a specific reference period before childbirth. This has created strong incentives for women and their employers to inflate reported earnings during pregnancy. The study finds a clear pattern of pre-pregnancy underreporting, with many women’s reported earnings clustered around the minimum wage. During pregnancy, however, reported earnings often jumped significantly, especially in smaller firms with fewer than 50 employees. These firms, typically prone to tax evasion, displayed a marked increase in reported wages during the six-month reference period to maximize benefits. After the 2015 reform, which reduced the reference period from one year to six months, these behaviors became even more pronounced. The average increase in reported earnings among pregnant women in small firms surged from 1.8% before the reform to 5.3% after it, illustrating how reforms amplified the incentive to manipulate earnings.

Small Firms Drive Informal-to-Formal Shifts

The study highlights the significant role of small firms in facilitating these adjustments. Small, less-productive firms, often engaged in tax evasion, were more likely to formalize informal earnings during pregnancy to maximize maternity benefits. The "bunching" of reported wages just below the benefit-maximizing threshold further underscores this strategic behavior. Interestingly, this phenomenon was absent in larger firms, where reported earnings among pregnant women often declined, likely due to health-related work interruptions or discrimination. Small firms also exhibited higher levels of formalization during pregnancy, as evidenced by a rise in the probability of women transitioning into formal employment. This suggests that smaller firms were more agile in adapting to the reforms and incentivizing compliance among employees.

Medium-Term Impacts on Formalization

One of the study’s most intriguing findings is the persistence of reported wage increases beyond the maternity leave period. Around half of the women who increased their earnings during pregnancy retained these higher levels of reported income after returning to work. This "stickiness" was particularly pronounced in smaller firms, where nominal wages often remained at the newly adjusted levels, even as minimum wages and benefit thresholds changed over time. These medium-term effects suggest that reforms encouraging higher reported earnings during pregnancy can have lasting impacts on formalization. However, the persistence of these effects varied significantly by firm size, with smaller firms showing greater long-term changes in reported earnings compared to larger organizations.

Balancing Incentives and Fairness in Social Security Systems

The findings underscore the dual-edged nature of linking social security benefits to contributions. While such systems can incentivize formal employment and reduce informality, they may also disadvantage certain groups. For example, women unable to adjust their reported earnings whether due to rigid employment contracts, discrimination, or health-related issues may receive fewer benefits. Furthermore, by tying benefits more closely to contributions, the system risks reducing its redistributive impact, potentially exacerbating inequalities. The study highlights the need for policymakers to balance these trade-offs when designing social security systems. Incentives for compliance must be weighed against the goal of ensuring equitable access to benefits, particularly for vulnerable populations.

Policy Lessons for Reducing Informality and Tax Evasion

This research contributes valuable insights into the broader discussions on tax evasion, labor market formalization, and social security design. The findings demonstrate how short-term incentives, such as those introduced by Hungary’s 2015 maternity benefit reforms, can drive significant changes in behavior. They also highlight the importance of considering firm size and productivity in policy design, as smaller firms were more responsive to the reforms. For policymakers in countries with high levels of informality, the study offers important lessons on leveraging contribution-based benefits to incentivize formalization. However, it also warns of the potential downsides, such as reduced equity and fairness, that must be addressed to ensure the broader success of such systems.

This paper, therefore, underscores the complexity of balancing tax compliance, labor market formalization, and social insurance equity. It suggests that while linking benefits to contributions can serve as a powerful tool for reducing tax evasion and informality, such approaches must be carefully calibrated to ensure that the benefits of increased compliance do not come at the expense of equity and fairness. With its detailed examination of Hungary’s maternity benefit reforms, the study offers a nuanced understanding of how policy changes can reshape behavior in the labor market, with lessons that extend far beyond the Hungarian context. These insights are particularly relevant for policymakers seeking innovative ways to tackle informality and improve the efficiency of social security systems.