By Gergely Szakacs

BUDAPEST (Reuters) -Hungary's parliament passed Prime Minister Viktor Orban's 2026 election year budget on Tuesday, including steep tax cuts for families, a key demographic for Orban's right-wing Fidesz party, shrugging off concerns over continued weak economic prospects.

Hungary's economic output was unchanged in the first quarter from a year earlier, while inflation ran at the European Union's highest levels, complicating the veteran leader's 2026 re-election bid.

The threat of U.S. tariffs on Europe looms large over Hungary's recovery prospects, while a stand-off with Brussels over Orban's judicial and other reforms has led to a suspension of EU funds, dealing another blow to Hungary's economy.

Even so, Orban's government is pushing ahead with large-scale tax cuts for families this year and next amid a strong challenge from a centre-right opposition party, which some polls show has overtaken nationalist Fidesz ahead of the election.

The Fiscal Council watchdog approved the budget as it projects a reduction in Hungary's debt, the EU's highest outside the euro zone, to 72.3% of output by the end of 2026 from 73.1% seen at the end of this year.

Hungary is targeting a budget deficit of 3.7% of output next year, compared with an estimated 4.1% gap in 2025. The European Commission sees the shortfall at 4.6% this year, rising to 4.7% in 2026.

While Orban's government has lifted the level of reserves to tackle contingencies, the Fiscal Council's key worries over slower economic growth and risks to EU funds were not addressed.

"Weaker-than-expected first-quarter 2025 GDP data and the trade tensions in the world economy pose downside risks to growth," the watchdog said.

"These represent substantial growth and fiscal risks for 2025, forming the basis of the (2026) budget, with (the risks) carrying over into 2026."

Hungary's debt inched up last year as the budget deficit came in at a higher-than-forecast 4.9% of output, while the economy eked out one of the lowest rates of growth in Europe.

Fitch Ratings, which affirmed Hungary's credit rating at 'BBB' with a stable outlook early this month, said a loose fiscal stance or weaker economic growth that prevents Hungary's debt from falling could lead to a rating downgrade.

A surge in the deficit in the first four months has prompted Orban's government to raise the 2025 deficit target and add $4 billion of borrowing from international markets, which will push the share of FX debt above a 30% threshold.

The government expects economic growth to accelerate to 4.1% next year from 2.5% projected for 2025 - an already-lowered target now under revision following weak first-quarter data.

The OECD sees Hungary's economy expanding by just 0.9% this year and 2.4% in 2026, well below the government's estimates.

($1 = 346.63 forints)

(Reporting by Gergely Szakacs; Editing by Alex Richardson)