Historical Background of Tax Reforms in Kenya
The structural adjustment program in the 1980 led to tax reforms with the aim to increase tax system but equity and progressivity was neglected. This led to the introduction of Tax modernization program adopted in 1986 which formed the foundation of the current tax system that led to several developments in the administration model, introduction of value added tax and the structure of personal income tax. In accordance with TMP, the Kenya Revenue Authority was launched in 1995 as an independent entity to increase the efficiency of the tax system. Other developments includes introduction of value added tax in 1990, introduction of Personal Income Tax under the income Tax Act, then, the iTAX a web-based application that allows persons to register electronically and file their taxes in 2014.
In 2020, the emergence of covid brought in economic shocks that made the government to reduce VAT from 16% to 14%, Corporate income tax from 30% to 25% and personal income tax in order to cushion the low income earners and small businesses from the economic shocks of the pandemic. Additionally, covid reduced the revenue of Kenya and necessitated increasing the tax base. As a result, there was adjustment of several tax incentives including capital and investment allowances as well as tax incentives provided in special zones and the implementation of new taxes such as Digital Services Tax. In April 2021, Kenya entered into a 38-month arrangement under the IMF’s Extended Credit Facility and Extended Fund Facility intended to adopt fiscal consolidation measures to facilitate efficiency in revenue collection.
Current tax system
Kenya’s tax administration system is split between the national and county governments. In Kenya, tax governance is primarily guided by the Constitution of Kenya, 2010 which outlines through article 209 the powers to impose taxes or raise revenue for both the national Government and the county government and which provides in article 210 that no tax can be imposed, varied, or waved without the process carried out through national legislation.
The Income Tax Act imposes personal income tax which is collected through self-assessment and Pay As You Earn (PAYE) whereby employers deduct from their employees’ income and remit it to KRA. Another tax is for Corporate Income Tax levied on corporate bodies on their annual income. Other taxes include withholding tax which is imposed on dividend payments, interest payments, professional fees, pension payments and insurance fees or commissions, Advance tax, and Instalment tax.
Digital Service Tax (DST) was introduced through the Finance Act 2019 imposed on any income made through the provision of services through a digital marketplace at the rate of 1.5% of gross transactional value without minimum threshold provided for the value of such transactions which led to concerns regarding its fairness and progressivity. In 2021, the Kenyan government through the Finance Act 2021, exempted its residents from DST so that DST would only be imposed on non-residents.
The indirect taxes value added tax (VAT) and excise tax are imposed under the Value Added Tax Act 2013 and the Excise Duty Act 2015. VAT is a consumption tax charged at each stage of the value chain in the production or distribution of goods or services, the threshold for registration is an annual turnover of KES 5,000,000. while Excise tax is charged on the sale or production of what are deemed ‘non-essential’ goods such as jewellery, confectionery amongst others.
Currently, Kenya only imposes a narrow range of wealth taxes including Capital Gains Tax at a rate of 5% on gains made from the transfer of property and property taxes.
Tax Burden and Progressivity
Kenya relies almost equally on both direct and indirect taxes. The Value Added Tax (VAT) system is regressive in nature as it is imposed on consumption irrespective of one’s income. However, essential goods such as food items as well as personal protective equipment (PPE) are either exempted or zero rated in light of the COVID-19 pandemic, and this makes the VAT less regressive. However, the tax system of petroleum products and clean energy materials are uncertain because the creation of exemption or zero rated list is highly politicized. Excise duties, traditionally used as “sin taxes” to influence consumption on alcohol, tobacco products and gambling and betting, have over time been expanded and deepened to include taxes on goods and services such as mobile data and money and financial transactions, bottled water, imported sim cards etc.
The potential of wealth taxes in Kenya has not been fully exploited especially with regard to property taxes. The revenue performance of wealth taxes such as Capital Gains Tax (CGT) is not publicly available as income tax and consumptions taxes such as VAT. It would also deem well for Kenya to introduce new forms of taxation such as inheritance tax and gift taxes.
Sufficient Revenues and Illicit Financial Flows
The tax-to-GDP ratio for Kenya while higher than the Sub-Saharan average, has decreased annually over the last five years despite overall increases in nominal revenue. The number of active taxpayers has also increased but not translated to increased revenue relative to active taxpayers. The policy frameworks around the taxation of extractives have been developed but have not yet been operationalised.
The Ministry of Finance has established mechanisms of promoting tax transparency through memberships to global bodies promoting exchange of tax information and administrative assistance on tax matters. Additionally, the Kenyan Revenue Authority (KRA) has established a Transfer pricing unit to counter tax abuses by multinational corporations. However, Kenya still grapples with revenue losses from Illicit Financial Flows (IFFs), currently estimated at USD 565 million per annum.
Kenya’s tax treaty network includes bilateral deals with fifteen countries, four of which are tax havens (Seychelles, South Africa, Netherlands and Mauritius) and four others are classified as very restrictive (France, Qatar, Zambia and South Korea). This means that these Double Taxation Agreements limit the taxing rights of Kenya. The current legal framework provides for a participatory process of ratifying international treaties, which includes cabinet, parliamentary scrutiny and public consultation.
Tax Competition and Corporate Incentives
Kenya provides a wide range of incentives in the form of capital deductions, tax holidays, special rates in free zones, exemption from certain income taxes, amongst others. While Kenya, may have the some of the highest standard Corporate Income Tax (CIT) rates in the East African region, it offers some of the most permissive incentives.
Estimates by the KRA indicate that Kenya lost up to 5.15% of its GDP in 2017 and 2.96% in 2020 (Tax Expenditures Report, 2021) through generous tax incentives. Tax holidays and incentives specific to Export Processing Zones are considered the most harmful but are not included in the 2021 report. This puts to question the cost-effectiveness of tax incentives in such zones, Kenya continues to pursue the use of free zones to attract foreign investment, by establishing Special Economic Zones. The proliferation of these incentives is worsened by a lack of coordinated regime in providing and administering the incentives within the free zones.
There is a growing lack of transparency in the administration of tax incentives in Kenya evidenced by her failure to publish tax expenditure information. This is despite the constitutional mandate to publish tax expenditures and the IMF recommendations on the country’s fiscal transparency..
The COVID-19 pandemic has had a positive impact on the reduction of tax incentives, especially with regard to capital deductions. Since the onset of the pandemic, the government is continuously doing away with redundant incentives. Further, the Kenyan government seeks to domesticate the country by country (CbC) reporting framework in order to enhance tax transparency.
Effectiveness of Tax Policy and Administration
Kenya performs poorly on actual collection of tax compared with the potential levels that could be collected. According to a 2018 publication by KRA, the average compliance gap for all tax heads stood at 30%, which translated to 6.6 % of the national GDP. Furthermore, Tax administration has undergone various reforms to boost revenue collections, including the automation of tax processes, increased investment in tax awareness campaigns and trade facilitation infrastructure. However, administration still faces challenges such as inadequate staffing. There is a need to especially build the capacity of county governments to collect revenue. County governments are short on technical capacity, proper legal frameworks as well as human resources in order to efficiently administer taxes.
Government Spending
Kenya has been unable to meet its commitments with regard to pro-poor spending in healthcare and agriculture. Healthcare financing has not met the Abuja Declaration 15% target except in the year 20202 due to its response to covid. Fiscal decentralisation has led to public services such as healthcare being devolved at county level. This has been met with many challenges including delayed disbursements of funds from the national government leading to situations whereby patients have to buy their own supplies to access healthcare. Agriculture is severely under-financed with more resources concentrated on renewable energy despite agriculture being one of the major contributors to Kenya’s GDP and food security being one of the key action plans in Kenya’s National Climate Change Action Plan. This comes at a time when Kenya is facing climate change related severe drought and famine. Also, It has consistently failed to meet the 10% Maputo commitment. Education in Kenya is the most financed social sector with the advent of Free Primary Education and capitation grants for secondary school tuition fees leading to increased enrolment. However, this has also led to the reduction of the quality of education due to congestion and the inadequacy of infrastructure. This sector requires increased development expenditure to meet these needs.
On the other hand, debt servicing takes up a large chunk of expenditure in Kenya. As of June 2021, according to the Public Debt Management Report, debt servicing as a percentage of revenue stood at 50%. Over the past 10 years, Kenya’s external debt stock has changed significantly with the growth of commercial loans. These foreign- currency dominated loans present a high refinancing risk for Kenya. In 2021, as a result of the economic shocks caused by the pandemic, Kenya was declared to be at high risk of debt distress and entered into an Extended Credit Facility and Extended Fund Facility with the IMF. These programmes have introduced fiscal consolidation measures that are likely to affect social spending.
Transparency and Accountability
Kenya has laws that allow for access to information including tax information. Tax information such as types of taxes, rates etc. is readily available on the KRA website. However, information regarding tax deals that is often within the ambit of the National Treasury is much more difficult to access. Kenya also has laws that require the disclosure of tax expenditures (TEs) implemented with the release of the first publicly accessible tax expenditure report in 2021 although can be improved under CIT as tax holidays were not captured. While KRA is audited on an annual basis by the independent body of the Office of the Auditor General, debate and action on the recommendations of the OAG is still lagging.
General corruption within the government affects tax compliance in Kenya and therefore stronger action needs to be taken against corruption including encouraging whistleblowing through the passing of the Whistleblower Protection Bill and any other relevant laws. Additionally, only publicly listed companies share their financial statements publicly even though company disclosure is a requirement. Beneficial ownership (BO) information requirements while highly commendable are only limited to companies and no other public vehicles such as partnerships and trusts. There is no public register of BO information.
Civil society engages with different arms of government on tax including the Ministry of Finance, KRA, the parliament and even the judiciary with certain degrees of success. However, it is necessary for a national level Public Participation Act to be enacted with specific focus on public finance engagement to provide more clarity to public participation processes.
Recommendations
First, Cost-benefit analyses should be carried out as we review the existing and planned tax incentives. Essentially, tax incentives should only be provided if the additional taxes revenues expected over the long term compensate for taxes foregone in the immediate or medium term, or if measurable positive externalities can be identified with equivalent effect. Secondly, the Government and Civil Society Organisations should increase the sensitisation of taxpayers of the need to pay taxes and demand better public services. Thirdly, KRA should work with county governments and use memorandums of understanding to improve their shared ways of working and collection easier. Additionally, KRA should have better access to databases from other public to empower the tax assessments of large business and rich individuals. Also, there is a need to increase the national budgetary allocation for social protection programmes.
In addition, civil society actors to engagement in debates about tax issues is encouraged, Increased national government spending in healthcare and agriculture is critical. Furthermore, counties need to increase Own Source Revenue (OSR) in order to meet their spending needs in these areas and reduce over-reliance on the national government. Finally, Increased scope of BO requirements to not only include companies but also trusts and partnerships to improve tax transparency.
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