Unlocking the Revenue Potential in Kenya

TABLE OF CONTENTS

CHAPTER ONE: BACKGROUND
1.1. Introduction
1.2. Domestic Resource Mobilization
1.3. The Concept of Tax Compliance
1.4. What is the Problem?
1.5. Objectives of the Study
1.6. Rationale of the Study

CHAPTER TWO: DEFINITION OF VARIOUS TAX HEADS
2.1. Income Tax
2.2. Value Added Tax (VAT)
2.3. Excise Duty
2.4. Trade Taxes

CHAPTER THREE: REVENUE COLLECTION TRENDS IN KENYA

CHAPTER FOUR: STUDY FINDINGS
4.1. Forecasting and setting of Revenue Targets in Kenya
4.2. Measuring the Tax Gap/ Tax Effort of Each of the Tax Heads
4.3. Impact of Underground Economy on Kenya’s Revenue Potential
4.4. The Impact of Taxpayer Behavior on Revenue Potential
4.5. Transfer Pricing and Revenue Potential
4.6. Impact of Tax Incentives on Revenue Potential
5.1. Overview of the Study
5.2: Recommendations/Way Forward

Annex 1: Analysis of Tax Gap: The Kenyan Case

Annex 2: Value Gap of Pharmaceuticals and Petroleum for 2007

CHAPTER ONE: BACKGROUND

1.1. Introduction

Understanding trends in Kenya's fiscal policy paradigm is important in giving direction on the salient issues behind unlocking the revenue potential of the country. Moreover, fiscal policy trend helps in appreciating the underlying external and internal environment that prevailed over time.

At independence, just like many commonwealth countries, Kenyainherited a British oriented tax system. Thus, as it were, the principles and fundamentals of taxation were based on the British model. The objective of the tax system during the pre-independence period was geared towards raising as much financial resources as possible from African households to finance the operations of the colonial Government. During this period little emphasis was given towards provision of basic goods and services in particular to the poorer segment of the society (Africans). Overall, this system was largely indifferent to the impoverished Africans and created exclusive dependency. For example, a hut tax was imposed on all households and male adults above the age of 18 years irrespective of their level of income.

Immediately after independence, the ideals of the First Republic are well articulated in Sessional Paper No. 10 of 1965 on Africa Socialism and its Application to Planning in Kenya. Overall, the blue print sought to build a nation devoid of illiteracy, disease and poverty. To this end all the revenue collected was supposed to fund projects addressing these three arch-enemies of development. According to Moyi et al (2003), over the period 1964–1977, the government of Kenya was able to finance all its current expenditure and part of its development expenditure using recurrent revenue receipts, and hence incurred minimal fiscal deficits. In addition, the country also operated on a healthy flow of donor assistance in terms of grants and project/programme aid. However, the situation did not last for long in the 1970s (after a series of both internal and external shocks), the government experienced persistent fiscal deficits. These deficits were attributed to the ballooning uncontrolled public expenditure and coupled with an inelastic tax system. To some extend it can be argued that the tax policy as well as tax administration measures did not manage to tame the situation.

In addition, the economy was also set back in August 1977 with the collapse of the East African Community (EAC), which ended favored access for Kenyan exports to Uganda and Tanzania. This included the breakup of the EAC revenue authority, and each country's tax administration was now wholly managed domestically. Overall, within a short span of only three to four years, Kenya had suffered a series of economic shocks that were far more severe than any problems previously confronted in the post-independence era.

Indeed, the tax system also mirrored the events of development. At independence, the tax system comprised of Income Tax, Sales Tax, Customs Duty and Excise Tax. These were mainly direct taxes that targeted income and consumption. Income tax policies in Kenya over the period appeared to lack a clear policy direction.The country faced a serious dilemma with regard to the use of income tax to attain equity, efficiency and savings. For example, in an attempt to address fiscal crises, Kenya replaced the existing consumption taxes with a sales tax in the fiscal year 1972/73. Sales tax was introduced with the aim of taxing specific types of goods to raise additional revenue. While it can be argued that this increase was a response to the emerging fiscal crisis occasioned by the high oil prices at the time, the prevailing tax rates were quite significant. The system was favorable not only because it targeted specific types of goods, but it also favored an inward-looking industrialization policy that the country was pursuing.

By early 1980s, the gaps in demand management tolls started slowly appearing. The debt hangover experienced in 1970s had spilled over into the 1980s. This coupled with economic mismanagement and fiscal indiscipline pointed towards the beginning of an economic downturn for Kenya. Key macroeconomic performance indicators began to waver. With this scenario in place, the donor community steped in and introduced Structural Adjustment Programmes (SAPs). Under the framework, the affected countries were required to rationalize economic governance by liberalizing their economies. It was then argued that liberalization would re-energize the moribund African economies to enhance efficiency in service delivery. All this was happening against a backdrop of lack of a strong base for revenue mobilization.

Owing to the above harsh economic environment, in 1986, the Government introduced a paper dubbed “Sessional Paper No. 1 on “Economic Management for Renewed Growth”. One of the key deliverables was to undertake a comprehensive Tax Modernization Programme (TMP) that would enhance domestic revenue mobilization. One of the key outputs of the Sessional Paper was the formation of Kenya Revenue Authority (KRA) in 1995. Despite the efforts made by the Government to mobilize resources domestically, challenges still remain. The next section gives an overview of Domestic Resource Mobilization (DRM) and its importance.

1.2. Domestic Resource Mobilization

Domestic resource mobilization (DRM) refers to the savings and investment generated by households, domestic firms, and government (Culpaper and Bahkshan, 2008). Enhanced DRM can help to reduce the external resources (in the form of grants and loans) required to achieve Millennium Development Goals (MDGs). Each additional $100 million equivalent raised through domestic taxation potentially reduces external debt liability up to an equivalent amount, thereby helping to constrain the growth of debt to sustainable (MDG-sustainable) levels (Culpeper and Kappagoda, 2007: 16). In the face of these considerations, domestic resource mobilization is inevitable in developing countries. However, it is an obvious point that enhanced domestic resource mobilization will not, by itself, guarantee efficient allocation of the mobilized resources.

The need for African countries to mobilize domestic resources as a medium-to long-term goal is now widely accepted. In the past, Africa has been rated poorly as relates to saving and investment. While savings performance varies between countries, African countries have lower savings and investment rates compared to other less developed countries. Elbadawi and Mwega (1998) argue that in 1997, domestic savings as a percentage of GDP was 17.6 percent (compared to 24 percent for all developing countries), while investment was 18.3 percent of GDP in contrast to the over 32 percent required for the poverty reduction target set.

A sustained increase in growth rates require a higher level of savings and investment as well as increased investment productivity. Thus, policies to promote savings have a central role to play in driving growth via investment and reducing aid dependency in Sub Saharan Africa (SSA), particularly in the face of the undisputed global reduction in aid. Identifying policies that promote savings (and the policies that inhibit it) is essential.

Developing countries and those in transition are at present confronting unsustainable fiscal deficits, unabated debt service charges, and declining external assistance seriously affecting their development process. It would be in their interest to overhaul the strategies of domestic and external financial resource mobilization through tax and non-tax instruments that are fair, equitable and create minimal disincentives for economic efficiency, and initiate tax reforms to simplify and rationalize the tax structure.

Domestic tax revenues are the most sustainable source of financing for public expenditures in developing countries. Various studies show that tax revenues are more stable and more predictable than foreign aid. In addition, they allow for more policy space owing to conditions attached to loans or grants. Enhancing direct tax revenues also has the potential to strengthen government accountability towards a country’s citizens rather than external donors or national elites.

From a Kenyan perspective, achieving the Millennium Development Goals (MDGs) will require a concerted effort from both developed and developing countries. Aid from developed countries will have to rise significantly to achieve the MDGs. The unpredictability of donor funds brings forth the need for developing countries and more so Kenya to unlock their revenue potential in order to meet the aforementioned MDG needs. It is also important to note the passage of the new constitutional dispensation presents the need for increased resources in order to meet the various needs envisaged. It is also important to note the goals envisioned in the Vison 2030 require massive resources and hence the need strengthening the tax base. Among the key sectors that require public sector investments to jump start the economy include infrastructure as well achieving equity and poverty reduction.

From a global perspective, one of the key resolutions of the United Nations Summit on MDGs in New York 2010 was the need for developing countries to Enhance and strengthen domestic resource mobilization and fiscal space, including, where appropriate, through modernized tax systems, more efficient tax collection, broaden the tax base and effectively combating tax evasion and capital flight. While each country is responsible for its tax system, there is need to support national efforts in these areas by strengthening technical assistance and enhancing international cooperation and participation in addressing international tax matters.

The role of government revenue and the capacity of governments to raise taxes for the purpose of financing economic development have preoccupied economists and policymakers for a long time. More than forty years ago, Kaldor (1963) raised the very important question of whether underdeveloped countries will “learn to tax”, with the underlying view that for these countries to reach higher standards of living, they would need to achieve levels of tax effort that are significantly higher than those observed at that time. Indeed, excessive reliance on foreign financing may in the long run lead to problems of debt sustainability and as such developing countries will need to rely substantially on domestic revenue mobilization.

1.3. The Concept of Tax Compliance

Tax Compliance refers to taxpayers’ adherence to tax laws voluntarily and to ensure correct tax obligations are fulfilled.

Tax compliance is divided into three categories:

- Administrative compliance: This refers to compliance with the administrative rules of lodging and paying taxes on time. This includes compliance with reporting requirements, procedural, and regulations;
- Technical compliance: This refers to compliance in the computation of taxes payable in accordance with the technical requirements/provisions of the tax laws; and
- Paying the right amount of tax.

Henry (1993) posits that “In attempting to measure compliance, it is important to know what is to be measured: evasion, avoidance, compliance or non-compliance. This depends on how compliance is defined: is it compliance according to the tax authority's or the taxpayer’s interpretation of the law and its application to the facts or is it from another more neutral perspective? Researchers have identified the lack of consensus in the unit of measurement as a key obstacle to progress”.

Decades of empirical work on tax compliance has produced awareness of the complexity of tax compliance and non-compliance behavior globally. Webley et al (1991) points out that tax compliance itself is now recognized as a multi-faceted construct. Many scholars such as Jackson et al (1986) have put forward some explanatory variables in analyses of tax compliance behavior.

In the midst of enormous diversity, a notably consistent theme over the past two decades of tax research has focused on identifying the costs, be they material, social or psychological, which would deter would-be tax evaders, and counter the lure of the benefits of evasion. A preoccupation with identifying costs and benefits with the goal of developing a risk profile for tax collection agencies has meant that less attention has been directed toward managing non-compliance once it has occurred.

Based on the available literature, the dominant environmental factors currently shaping the performance of revenue administrations in developing countries are globalization, large informal sectors, and limited administrative capacity. Tax policy and administrative reforms generally have one or several of the following objectives:

(i) Increasing the equity of the tax system;
(ii) Creating an enabling environment for private sector development; and
(iii) Increasing revenue collection or compliance.

On the implementation side, the challenge to coordinate policy reforms with parallel reforms in tax administration has rarely been fully addressed. Yet the menu of administrative reform options has been greatly enriched with new approaches to organizational design, taxpayer services, ICT solutions, human resource incentives, and formal anti-corruption strategies. Compliance management is no longer based purely on an enforcement-focused approach, but on a combination of enforcement and enhanced taxpayer services.

The issue of tax compliance is extremely important both to those concerned with the key role increased tax yields can play in restoring macroeconomic balance and to those concerned with tax policy and its effects on the economy in general. The level of tax collection though important is an unsophisticated measure of the effectiveness of tax administration. A more accurate measure is the level of compliance. Facilitating compliance involves such elements as improving services to taxpayers by providing clear instructions, easy to fill forms and assistance and educating them on their duties and obligations.

Monitoring compliance requires establishing and maintaining current accounts of taxpayers and management information systems covering both ultimate taxpayers and third party agents such as banks involved in the tax system as well as appropriate and prompt procedures to detect and follow up on non filers, nil filers and delayed payments. Deterring noncompliance requires establishing both a reasonable risk of detection as well as applying penalties effectively. The ideal approach is to combine these measures so as to maximize their effect on compliance- as it were, to move a country from a “low compliance” to a “high- compliance environment”.

1.4. What is the Problem?

The ability of developing countries’ governments to raise direct tax revenues is constrained by a number of external and internal factors. External factors include trade liberalization, which reduces revenues from customs duties, and tax avoidance and evasion by multinational corporations and wealthy individuals, sometimes involving tax havens and harmful tax measures by other countries, regional integration and conventions and Treaties that countries often get into. This is often compounded by undeveloped domestic economy that has tendencies to encourage small trading often called in Kenya “The Kadogo economy^[1] ”. Internal factors include a lack of capacity of revenue authorities and low tax compliance. Developing country governments may also offer irrational tax breaks to large investors due to a variety of internal and external pressures.

The Kenya government relies on tax revenues for both its recurrent and development expenditure. In pursuit of this, KRA has been mandated to assess and account for all taxes due to the government. Frequent reforms are gradually replacing trade taxes with domestic consumption taxes, particularly the VAT, therefore placing great importance on VAT and income taxes in general. The low compliance levels and tax evasion creates a narrow tax base and high enforcement costs. A study conducted by KRA, KIPPRA and the Treasury, based on 1999/2000 data, revealed that VAT payment compliance was as low as 55% while return lodgment compliance was 65%.

Large amounts of taxes are collected from the easy-to-tax areas such as public wage earners while enforcement of collection among small business enterprises is difficult. These are the earners with the lowest compliance due to the high enforcement cost faced by the tax authorities. Tapping into this group of taxpayers can significantly increase the revenue collection.

Key interest by legislators has been limited to reviewing the various legislative provisions and their impacts to large and multinational actors in the economy; appropriation and allocation of funds for Government expenditures. This has therefore relegated initiatives that monitor Government revenues in particular the manner in which the targets are set and the reality check of whether and why the targets are not met to the periphery.

1.5. Objectives of the Study

This study seeks to establish the ways and means of unlocking Kenya’s revenue potential. Specifically, the study seeks to:

i. Unpack the criteria used in setting up targets;
ii. Analyze the trends in revenue collection including identifying the reasons as to why the targets are not met in the recent years
iii. Identify areas that have exemptions, the revenue ,the rationale of granting the same regime, and the role of the various players in the regime; and
iv. Identify the various untaxed areas and come up with strategies (legislative or administrative) of they can be brought into the tax net.
v. Establish the tax gap and suggest measures that can ensure the gap is closed.

1.6. Rationale of the Study

There is a growing concern that just as Parliament is focusing on expenditure issues, there is need to also focus on the revenue side of the budget. Indeed, parliament can provide the necessary legal backing to various revenue agencies as this will provide autonomy required in revenue collection. In addition, MPs can also introduce tax measures in the form of amendments and ensure constant review of tax rates. Moreover, parliament can also investigate why revenue targets have not been met and identify areas of leakages in addition to the corresponding measures to address them.

Besides tax revenue, the relevant committees should explore other channels of financing the budget such as Appropriation in Aid. Ministries should be put to task on non tax revenue they are expected to collect. Lastly, the relevant committees can institute sensitization and awareness measures to members of the public on the importance of paying taxes by explaining to them the key results that have been achieved; this could include the various project intervention made possible with Constituency Development Fund (CDF) resources.

CHAPTER TWO: DEFINITION OF VARIOUS TAX HEADS

Kenya at independence had income tax, trade taxes and excise taxes. Income tax is divided into four separate categories: Personal Income Tax (PIT), Pay as You Earn (PAYE), Corporate Income Tax (CIT) and Withholding Tax (WHT). Personal Income Tax (PIT) is a tax on income from individual businesses paid largely by self-employed self-assessment income tax returns for their businesses to show income and deductible business expenses. They then pay PIT on the profits. Value-added taxes were introduced later. This section gives the definition of various taxes.

2.1. Income Tax

(a) Personal and Corporate Income Tax

Income tax is levied on individuals, corporations and certain specified earnings. It takes the form of tax on actual earned income in the case of individuals and on company profits. A withholding tax is charged on other sources of income including royalties, dividends and rental income among others. These taxes generally capture formal sector business profits and employment income only.

Income from employment is also taxable and is subject to Pay as You Earn (PAYE). Under the PAYE system the employer, as an agent of the tax authority, is required to recover tax on employment income includ­ing the value of all benefits except medical ones. That income is taxed in full, as expenses are not deductible in the case of employment income. In the cases of both PIT and PAYE, tax is charged at the same graduated scale tax rate but on different tax.

(b) Withholding Tax

Withholding taxes are deducted at source from the following sources of income: Interest, dividends, royalties, management or professional fees, commissions, pension or retirement annuity, rent, appearance or performance fees for entertaining, sporting or diverting an audience. Table 1 shows the schedule of withholding tax.

Table 1: Schedule of Withholding Tax.

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Source:-www.kra.go.ke

(c) Advance Tax

Advance tax is applicable to Matatus and other Public Service Vehicles. It is not a final tax, but a tax partly paid in advance before a public service vehicle or a commercial vehicle is registered or licensed. The current rates are:

- For vans, pickups, trucks and Lorries Kshs.1,500 per ton of load capacity per year or Kshs.2, 400 whichever is higher.
- For saloons, station wagons, mini-buses, buses and coaches, Kshs.60 per passenger capacity per month or Kshs.2, 400 whichever is higher.

2.2. Value Added Tax (VAT)

Value Added Tax (VAT) is a tax on consumer expenditure introduced in Kenya in January 1990 to replace Sales Tax, which had been in operation since 1973. VAT was introduced as a measure to increase Government revenue through the expansion of the tax base, which hitherto was confined to sale of goods at manufacturing and importation level under the sales tax system. Value Added Tax is a multistage consumption tax ap­plied to the sale of goods and services at all stages of the production and distribution chain. Only registered traders are required to charge VAT, and for a trader to qualify for registration under VAT, he or she must have an annual sales turnover of Kshs.3 million.

VAT is levied on consumption of taxable goods and services supplied or imported into Kenya and are collected by registered persons at designated points who then remit it to the Commissioner. Registered persons only act as VAT agents in collecting and paying the tax since the tax is borne by the final consumer of goods and services. The basic law is contained in the Value Added Tax Act, Cap. 476 of the Laws of Kenya and the Regulations stemming from it.

(a).The Scope of Tax

Value Added Tax is charged on the supply of taxable goods or services made or provided in Kenya and on the importation of taxable goods or services into Kenya. Taxable goods and services are contained in the various schedules to the VAT Act. The VAT Act constitutes the following schedules (table 2): -

Table 2: Schedule for VAT in Kenya

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Source: www.kra.go.ke

(b).Tax Rates

There are three tax rates as specified in the schedules to the VAT Act, which are:

- 16%: This is the general rate of tax and is applicable to all taxable goods and taxable services.
- 14%: This is applicable to only hotels and restaurants services. It is applicable to:

i) Restaurant services (including bar & beverage services) offered by a restaurant owner or operator.
ii) Accommodation and all other service provided by hotel owner or operator including telecommunications, entertainment, laundry, dry cleaning, storage, safety deposits, conference and business services.

NB: Designated goods such as cigarettes, matches, gift items, confectionaries and other articles sold over the counter or in mini shops within the hotels and restaurants are taxable at the general rate of 16%.
- 0%: This applies to certain categories of goods and services, which includes exports, agricultural inputs, pharmaceutical products and supplies to privileged persons. The purpose of zero rating is to make the supplies cheaper as the dealers in these goods can claim back any input tax incurred in the course of their business.

2.3. Excise Duty

It is a duty imposed on goods and services manufactured in Kenya or imported into Kenya as specified in the 5th Schedule of the Customs and Excise Act Cap 472 of the Laws of Kenya. The Excise duty on locally manufactured excisable goods and services is payable to the Commissioner of Domestic Taxes at the rates specified in the 5th Schedule. Excise duty on imported goods and services is accounted to the Commissioner, Customs Services Department.

The duty on locally manufactured excisable goods is charged at the rate in force when goods liable are delivered from an excise stock room or when services are rendered. The amount of duty charged is payable, through an excise return, to the Commissioner, Domestic Taxes, on or before the 20th date of the month following the month in which the goods/services sold or offered.

Kenya’s excisable commodities at the moment are alcoholic beverages, soft drinks, mobile air time, bottled water, tobacco, fuel, cosmetics, jewellery and motor vehicles. Excise tax rates are particularly high in cases where a negative impact results from consuming harmful goods or services, or in cases of luxury goods that have a lesser substitution effect even with higher tax rates.

2.4. Trade Taxes

Trade taxes are taxes on exports and imports. Customs or import duty is the most dominant of the trade taxes and is charged on the CIF value (cost value including insurance and freight) of imported goods based on tariff bands ranging from 0 to 100 per cent.

Tax levied on imports (and, sometimes, on exports) by the customsauthorities of a country to raise state revenue, and/or to protect domesticindustries from more efficient or predatory competitors from abroad. Also called tariff, duty is based generally on the value of goods (called ad valorem duty) or upon the weight, dimensions, or some other criteria of the item (such as the size of the engine, in case of automobiles).

CHAPTER THREE: REVENUE COLLECTION TRENDS IN KENYA

Over the period of 1995 to 2009 KRA has been successful in meeting its mandate. Revenue collection rose from Kshs.122 billion in 1995/96 to Kshs.480.billion in 2008/09. Overall, revenues have grown by an annual average of 14.1 per cent over the period to 2008/09.

Figure 1: Propositions of Various Sources of Ordinary Revenues in 2008/2009

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Source: KRA

Appropriations in Aid mainly consist of all other non tax revenues such as user fees and charges, fines, penalties and forfeitures; social security contributions; income from Government property; proceeds from sale of goods and services; repayments from domestic lending and on-lending; Proceeds from Government Investments among other receipts not classified anywhere. A-in-A forms a lower proportion of the total revenue compared to the Ordinary revenues which are mainly taxation proceeds.

Figure 2: Composition of Total Revenues in 2008/2009 Financial Year

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Source: KRA

Over the period 1980-1999, all the components of revenue were increasing due to rising buoyancy and elasticity occasioned by the rapidly growing economy. However, over 2000-2002 (as a ratio of GDP), most tax heads (apart from VAT) exhibited a downward trend.

The next upsurge of revenue was over the year 2002-2005. This can be attributed to improved tax administration in response to tax reforms that started in 2002/2003. Figure 1 shows revenue trends as shares of GDP for Kenya, 1980-2006.

Over the last forty years, tax collection while having gradually improved has experienced large fluctuations when measured as a ratio of actual tax share of gross do­mestic product (GDP). Revenue collection has recently increased, and has now reached the GDP levels that existed in the early 1990s (Figure 2).

Figure 3: Composition of Government Revenue 1971-2008 as a Percentage of Tax per GDP

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Source: Economic Survey (Various Issues)

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^[1] Kadogo Economy refers to a situation whereby due to the shrinking income most of the population are forced to purchase consumables in small quantitative.