Design and Performance of Kenya’s Tax System: An Inequality Perspective

The effectiveness of using taxation as a redistributive tool depends on the design of the tax system. The Kenyan tax system comprises two main direct taxes (individual income and corporate taxes), and three main indirect taxes (Value Added Tax, Excise tax and Customs duties). Usage of income taxes has declined over time. However, income taxes still contribute the largest share of total tax revenue. There has been a deliberate shift towards indirect taxes. The design and performance of the tax system has implications on inequality. Under income taxes, widening of tax brackets, reduction of the top marginal tax rates and increasing the levels of personal relief have made income tax progressive and equitable. However, exemption of low-income individuals from the tax net limits the effectiveness of the income tax as a redistribution tool given that income tax payers are a small proportion of the population. VAT is considered highly regressive, but the analysis shows that the use of exemptions and zero-rating of specific commodities that are mainly consumed by low-income earners has made the system more progressive and thus more equitable. The equity objective under excise taxes has mainly been pursued through use of high and largely differentiated rates on goods that are considered luxurious. Overall, there has been increased reliance on indirect taxes as opposed to direct taxes, which has had implications on using the tax system to achieve income redistribution. However, the regressivity of consumption taxes can be overcome by use of exemptions and zero-rating of basic commodities. Taxation of wealth and property income can play an important role in income redistribution but still remains a big challenge. Also, the fast growing informal sector undermines the use of tax policy to achieve redistributive goals. In conclusion, the effectiveness of using tax policy to achieve redistribution objectives cannot be underestimated, even though research has shown that equity objectives are better pursued through expenditure policies rather than taxation. I acknowledge review comments by Prof. Francis Mwega, Prof. Terry Ryan, Dr. Mbui Wagacha, Mr. Njeru Kirira and Mr. Jocelyn Ogai. Readings on Inequality in Kenya: Sectoral Dynamics and Perspectives 58 2 Even though these principles (equity, efficiency and simplicity) are either complementary or trade offs. 3 The challenge, therefore, is to come up with an appropriate welfare measure. 4 Policies are pro-poor if the social and economic indicators for the disadvantaged people improve more rapidly than those for the rest of the society (Vandemoortele, 2004). Introduction Governments need money. Modern governments need lots of money. How they get this money and whom they take it from are two of the most difficult political issues faced in any modern political economy (Steinmo, 1993 as quoted by Hardiman, 2004) From the mediaeval times, political authority has been used to raise finances for the operation of governments. One way of raising finances is through taxation. In practice, there are three common objectives of tax systems: (i) to raise revenue to fund government operations; (ii) to assist in the redistribution of wealth or income; and (iii) to encourage or discourage certain activities through the use of tax provisions (Karingi and Wanjala, 2005). In addition to the above objectives, taxation can also be used as a stabilization tool, whereby various instruments are adjusted depending on the economic situation of the country. The extent to which these objectives are met differs from country to country. There are several principles that guide tax policy. The most commonly cited principles are adequacy, equity, exportability, neutrality and simplicity. Neutrality implies that imposing a tax does not distort economic decisions. This is one of the strong arguments for imposing sales tax. Simplicity implies that the tax collection and assessment system does not impose costs greater than the revenue raised, and the tax code should also be easily understood by tax payers. An adequate tax system, on the other hand, raises enough money to pay for public services. Exportability refers to the extent to which taxes are paid for by non-residents, for example an export tax. This is not an important aspect of Kenya’s tax system. The principle of equity is the main concern of this Chapter. A tax system is equitable if it is fair. There are two measures of equity–horizontal and vertical equity. A system is horizontally equitable if persons or businesses in similar circumstances (in terms of welfare) have similar tax burdens. Taxes that affect one group (such as wage-earners) more harshly than another (such as investors) are not equitable. Income tax is an example of this disparity. Progressivity and regressivity are underlying concepts under vertical equity, which are defined in terms of welfare positions. Regressive taxes require lower-income families to pay a greater percentage of their income in tax than upper-income families. The classic regressive tax is a sales tax; this is why some governments zero-rate basic commodities as a means of making the system more pro-poor. The sales tax in most cases has been applied as a uniform commodity tax and excludes leisure, which is one of the commodities consumed by economic agents, thereby impacting on resource allocation.