Is Kenya’s Tax System Efficient, Optimal, and Equitable?
Category: Taxation
By: Leo Kipkogei Kemboi,
In my new paper, “On Efficiency, Equity, and Optimal Taxation: Reforming Kenya’s Tax System,” I examine Kenya’s tax system through the lenses of efficiency, equity, and optimality and recommend policy recommendations. I try to look at how efficiently the system generates revenue without distorting economic activity (efficiency), how fairly the tax burden is distributed across income groups and sectors (equity), and what strategies can balance revenue generation with fairness while taking into account both the Kenyan context and international best practices (optimal taxation). Using current literature, I present a framework for assessing these elements and propose feasible modifications. It emphasizes the importance of these three concepts in tax reform and serves as a foundation for future study and policy proposals. Here are the main key findings.
1.Distributional Burden of the Tax: In Article 201 on the Principles of Public Finance, the Constitution of Kenya states explicitly that “the burden of taxation shall be shared fairly.” This principle emphasizes the intention to create an equitable tax system where the responsibility of contributing to public finances is distributed justly among the Kenyan population. Kenya’s tax system relies on a balanced mix of direct and indirect taxes to generate revenue. Income tax, levied on the earnings of individuals and corporations, forms the system’s backbone, consistently contributing around 45% of total tax revenue. Kenya’s taxation system is primarily borne by fewer firms and those in the formal sector. The central challenge isn’t simply taxation but rather economic growth. A more robust economy requires diversification, export competitiveness, and a thriving service sector.
2. Tax Buoyancy: Kenya’s tax buoyancy analysis reveals several challenges, indicating areas where the tax system struggles to capitalize on economic growth fully. One key issue is fluctuating buoyancy levels. The inconsistent relationship between GDP growth and tax revenue over the years complicates revenue forecasting and fiscal planning. Another challenge lies in the underperformance of import duty, which often lags behind GDP growth. This could be attributed to trade policy changes, reduced import volumes, or a reliance on other revenue sources. It suggests inefficiency in leveraging international trade for revenue. Excise duty revenue also exhibits significant volatility, likely due to fluctuating tax rates on specific goods, shifting consumer behaviour, and changing economic conditions. This instability undermines its reliability as a consistent revenue source. While Value Added Tax has generally performed well, its buoyancy has shown some variability. External factors like consumer spending patterns and enforcement challenges may affect its ability to sustain revenue growth. Income tax, too, has faced challenges. Although recent improvements suggest strengthened enforcement and policy reforms, its initially low buoyancy highlights historical tax administration and compliance weaknesses. Some components of the tax system may be regressive, failing to target economic growth benefits adequately. This occurs when the tax structure disproportionately impacts lower-income groups or excludes significant segments of the economy. The fluctuations in tax buoyancy across different categories point to the influence of inconsistent tax policies, administrative inefficiencies, and varying degrees of compliance enforcement over time. These issues underscore the need for Kenya to adopt reforms focused on broadening the tax base, improving compliance, ensuring stability in tax revenues, and aligning tax policies with economic growth trends.
3. Failure to incorporate Tax Elasticity in Tax Proposal Formulation: Kenya faces significant challenges in managing tax elasticity, particularly concerning essential commodities like fuel. The high price elasticity of demand for certain goods, such as kerosene (PED = -4.13), creates a dilemma. Even small tax or price increases lead to substantial drops in consumption, potentially diminishing overall tax revenue and disproportionately impacting low-income households who rely on these commodities. This high elasticity introduces revenue uncertainty, making fiscal planning difficult for the government, as revenue projections can be unreliable due to the varying elasticities across different fuel types like petrol and diesel. The social equity implications are also substantial. Tax increases on essential fuels like kerosene exacerbate energy poverty, forcing vulnerable households to reduce consumption or switch to potentially harmful and less efficient alternatives like charcoal or firewood. The elastic responses to price changes, especially for diesel, which is crucial for transportation and industries, can negatively impact the broader economy. Reduced industrial productivity, increased logistics costs, and inflationary pressures can hinder economic growth and employment. The presence of high elasticity also creates market distortions. Consumers are incentivized to substitute highly taxed fuels like kerosene and diesel with untaxed or less taxed options, such as electricity or biomass. This substitution shrinks the tax base, further undermining government revenue collection efforts and potentially promoting environmentally or economically undesirable alternatives. Ultimately, policymakers must grapple with difficult trade-offs. Increasing fuel taxes can generate revenue, but risks reducing consumption, while lowering taxes to improve affordability can erode government revenue needed for essential public services. Finding a balance that addresses revenue needs and social welfare concerns remains a complex challenge.
4. What are tax equity problems in Kenya? Kenya faces significant tax equity challenges, particularly in achieving horizontal and vertical equity. Horizontal equity, the principle of treating equals equally, is undermined by several factors. Wide tax bands covering broad income ranges result in individuals with vastly different incomes within the same bracket paying the same marginal tax rate—for example, someone earning Ksh. 400,000 annually faces the same 30% rate as someone earning Ksh. 9,000,000, disproportionately impacting the lower earner. This creates an unequal tax burden, as the same tax rate represents a larger portion of disposable income for lower earners. The lack of nuance within these broad bands further reduces the system’s responsiveness to individual financial circumstances. Vertical equity, the principle of taxing those with greater ability to pay at higher rates, also faces challenges. While Kenya’s system is nominally progressive, the progression between bands, especially at higher income levels, cannot address income inequality—the minimal jump from 32.5% to 35% for incomes exceeding Ksh. 9,600,000 does little to tax higher earners proportionally. Furthermore, like personal relief, flat tax reliefs disproportionately benefit higher earners as they represent a smaller percentage of their overall income. These issues create incentives for tax avoidance and evasion. Large gaps between marginal tax rates encourage strategies like underreporting income to remain in lower brackets. High rates and perceived inequities also contribute to non-compliance within Kenya’s large informal sector, exacerbating the divide between those who pay taxes and those who evade them.
5. Does the system consider Deadweight Loss
5.1 Deadweight Loss on Motor Spirit (Petrol). In June 2023, Kenya’s Motor Spirit (petrol) market recorded a consumption of 121,340,000 litres at Ksh 182.63 per litre, resulting in a market size of Ksh 22.16 billion. However, the market dynamics shifted by July 2023, likely influenced by a price increase. The price of Motor Spirit rose to Ksh 195.32 per litre, a Ksh 12.69 increase. This price hike led to a contraction in demand. Consumption in July decreased to 112,640,000 litres, reflecting a reduction of 8,700,000 litres. The calculated deadweight loss for this period is substantial, estimated at Ksh 55,201,500.
5.2 Deadweight Loss on Diesel: In June 2023, Kenya’s light diesel oil market saw robust activity, with 187,860,000 litres consumed at Ksh 167.98 per litre, generating a market size of Ksh 31.56 billion. However, the landscape changed significantly by July 2023, following a VAT increase on fuel from 8% to 16%. This tax change contributed to a price hike, pushing the AGO price to Ksh 180.42 per litre – a Ksh 12.44 increase, which brought a deadweight loss in the market of Ksh 106.299 million.
5.3 Deadweight Loss on Illuminating Kerosene. In June 2023, the Kenyan market for Illuminating Kerosene saw consumption of 5,370,000 litres at Ksh 162.19 per litre, leading to a market size of Ksh 0.871 billion. Come July 2023, the price of Illuminating Kerosene experienced an upward shift, reaching Ksh 170.25 per litre, marking an increase of Ksh 8.06. This price increase resulted in a demand contraction. Consumption in July declined to 4,270,000 litres, representing a reduction of 1,100,000 litres and a deadweight loss of 4.4 million.
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Is Kenya’s Tax System Efficient, Optimal, and Equitable?
| Post date: Thu, Nov 28, 2024 |
| Category: Taxation |
| By: Leo Kipkogei Kemboi, |
In my new paper, “On Efficiency, Equity, and Optimal Taxation: Reforming Kenya’s Tax System,” I examine Kenya’s tax system through the lenses of efficiency, equity, and optimality and recommend policy recommendations. I try to look at how efficiently the system generates revenue without distorting economic activity (efficiency), how fairly the tax burden is distributed across income groups and sectors (equity), and what strategies can balance revenue generation with fairness while taking into account both the Kenyan context and international best practices (optimal taxation). Using current literature, I present a framework for assessing these elements and propose feasible modifications. It emphasizes the importance of these three concepts in tax reform and serves as a foundation for future study and policy proposals. Here are the main key findings.
1.Distributional Burden of the Tax: In Article 201 on the Principles of Public Finance, the Constitution of Kenya states explicitly that “the burden of taxation shall be shared fairly.” This principle emphasizes the intention to create an equitable tax system where the responsibility of contributing to public finances is distributed justly among the Kenyan population. Kenya’s tax system relies on a balanced mix of direct and indirect taxes to generate revenue. Income tax, levied on the earnings of individuals and corporations, forms the system’s backbone, consistently contributing around 45% of total tax revenue. Kenya’s taxation system is primarily borne by fewer firms and those in the formal sector. The central challenge isn’t simply taxation but rather economic growth. A more robust economy requires diversification, export competitiveness, and a thriving service sector.
2. Tax Buoyancy: Kenya’s tax buoyancy analysis reveals several challenges, indicating areas where the tax system struggles to capitalize on economic growth fully. One key issue is fluctuating buoyancy levels. The inconsistent relationship between GDP growth and tax revenue over the years complicates revenue forecasting and fiscal planning. Another challenge lies in the underperformance of import duty, which often lags behind GDP growth. This could be attributed to trade policy changes, reduced import volumes, or a reliance on other revenue sources. It suggests inefficiency in leveraging international trade for revenue. Excise duty revenue also exhibits significant volatility, likely due to fluctuating tax rates on specific goods, shifting consumer behaviour, and changing economic conditions. This instability undermines its reliability as a consistent revenue source. While Value Added Tax has generally performed well, its buoyancy has shown some variability. External factors like consumer spending patterns and enforcement challenges may affect its ability to sustain revenue growth. Income tax, too, has faced challenges. Although recent improvements suggest strengthened enforcement and policy reforms, its initially low buoyancy highlights historical tax administration and compliance weaknesses. Some components of the tax system may be regressive, failing to target economic growth benefits adequately. This occurs when the tax structure disproportionately impacts lower-income groups or excludes significant segments of the economy. The fluctuations in tax buoyancy across different categories point to the influence of inconsistent tax policies, administrative inefficiencies, and varying degrees of compliance enforcement over time. These issues underscore the need for Kenya to adopt reforms focused on broadening the tax base, improving compliance, ensuring stability in tax revenues, and aligning tax policies with economic growth trends.
3. Failure to incorporate Tax Elasticity in Tax Proposal Formulation: Kenya faces significant challenges in managing tax elasticity, particularly concerning essential commodities like fuel. The high price elasticity of demand for certain goods, such as kerosene (PED = -4.13), creates a dilemma. Even small tax or price increases lead to substantial drops in consumption, potentially diminishing overall tax revenue and disproportionately impacting low-income households who rely on these commodities. This high elasticity introduces revenue uncertainty, making fiscal planning difficult for the government, as revenue projections can be unreliable due to the varying elasticities across different fuel types like petrol and diesel. The social equity implications are also substantial. Tax increases on essential fuels like kerosene exacerbate energy poverty, forcing vulnerable households to reduce consumption or switch to potentially harmful and less efficient alternatives like charcoal or firewood. The elastic responses to price changes, especially for diesel, which is crucial for transportation and industries, can negatively impact the broader economy. Reduced industrial productivity, increased logistics costs, and inflationary pressures can hinder economic growth and employment. The presence of high elasticity also creates market distortions. Consumers are incentivized to substitute highly taxed fuels like kerosene and diesel with untaxed or less taxed options, such as electricity or biomass. This substitution shrinks the tax base, further undermining government revenue collection efforts and potentially promoting environmentally or economically undesirable alternatives. Ultimately, policymakers must grapple with difficult trade-offs. Increasing fuel taxes can generate revenue, but risks reducing consumption, while lowering taxes to improve affordability can erode government revenue needed for essential public services. Finding a balance that addresses revenue needs and social welfare concerns remains a complex challenge.
4. What are tax equity problems in Kenya? Kenya faces significant tax equity challenges, particularly in achieving horizontal and vertical equity. Horizontal equity, the principle of treating equals equally, is undermined by several factors. Wide tax bands covering broad income ranges result in individuals with vastly different incomes within the same bracket paying the same marginal tax rate—for example, someone earning Ksh. 400,000 annually faces the same 30% rate as someone earning Ksh. 9,000,000, disproportionately impacting the lower earner. This creates an unequal tax burden, as the same tax rate represents a larger portion of disposable income for lower earners. The lack of nuance within these broad bands further reduces the system’s responsiveness to individual financial circumstances. Vertical equity, the principle of taxing those with greater ability to pay at higher rates, also faces challenges. While Kenya’s system is nominally progressive, the progression between bands, especially at higher income levels, cannot address income inequality—the minimal jump from 32.5% to 35% for incomes exceeding Ksh. 9,600,000 does little to tax higher earners proportionally. Furthermore, like personal relief, flat tax reliefs disproportionately benefit higher earners as they represent a smaller percentage of their overall income. These issues create incentives for tax avoidance and evasion. Large gaps between marginal tax rates encourage strategies like underreporting income to remain in lower brackets. High rates and perceived inequities also contribute to non-compliance within Kenya’s large informal sector, exacerbating the divide between those who pay taxes and those who evade them.
5. Does the system consider Deadweight Loss
5.1 Deadweight Loss on Motor Spirit (Petrol). In June 2023, Kenya’s Motor Spirit (petrol) market recorded a consumption of 121,340,000 litres at Ksh 182.63 per litre, resulting in a market size of Ksh 22.16 billion. However, the market dynamics shifted by July 2023, likely influenced by a price increase. The price of Motor Spirit rose to Ksh 195.32 per litre, a Ksh 12.69 increase. This price hike led to a contraction in demand. Consumption in July decreased to 112,640,000 litres, reflecting a reduction of 8,700,000 litres. The calculated deadweight loss for this period is substantial, estimated at Ksh 55,201,500.
5.2 Deadweight Loss on Diesel: In June 2023, Kenya’s light diesel oil market saw robust activity, with 187,860,000 litres consumed at Ksh 167.98 per litre, generating a market size of Ksh 31.56 billion. However, the landscape changed significantly by July 2023, following a VAT increase on fuel from 8% to 16%. This tax change contributed to a price hike, pushing the AGO price to Ksh 180.42 per litre – a Ksh 12.44 increase, which brought a deadweight loss in the market of Ksh 106.299 million.
5.3 Deadweight Loss on Illuminating Kerosene. In June 2023, the Kenyan market for Illuminating Kerosene saw consumption of 5,370,000 litres at Ksh 162.19 per litre, leading to a market size of Ksh 0.871 billion. Come July 2023, the price of Illuminating Kerosene experienced an upward shift, reaching Ksh 170.25 per litre, marking an increase of Ksh 8.06. This price increase resulted in a demand contraction. Consumption in July declined to 4,270,000 litres, representing a reduction of 1,100,000 litres and a deadweight loss of 4.4 million.
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Introduction The Finance Bill 2024 in Kenya sparked a wave of collective action primarily driven by Gen Z, marking a significant moment for youth engagement in Kenyan politics. This younger generation, known for their digital fluency and facing bleak economic prospects, utilised social media platforms to voice their discontent and mobilise protests against the proposed […]
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