In response to the economic consequences of the coronavirus, the Government of Kenya (like other governments) has pursued important tax changes that deliver useful benefits to small businesses and formal-sector workers with lower incomes, but also provide poorly justified tax cuts for large businesses and individuals with higher incomes.
At this time of crisis, government policies should be focused on the population that is least able to fend for itself, rather than on providing relief to the most fortunate citizens. Because governments in low- and middle-income countries have less scope for borrowing and face greater risk of currency depreciation, they must also be more cautious about revenue-reducing measures that further exacerbate likely collapses in tax collection due to the economic slowdown and an already tenuous fiscal position. Targeted policies that benefit the most vulnerable are not only equitable: they ensure that limited resources are used well while continuing to collect revenue from those that can afford to pay.
Kenya’s parliament has acted to promote equitable tax policies…
Parliament plays an important oversight role in examining government’s pandemic response, and it has been sensitive to equity concerns when reviewing tax policy proposals in the country. For example, Parliament’s actions included:
- Rejecting a proposed VAT increase on agricultural inputs like fertilizer and animal feeds, arguing it was inequitable and damaging to food security. According to latest Census numbers, 52 percent of Kenya’s 12.1 million households engage in farming (most in crop farming), and therefore, an increase in VAT on farm inputs would affect most Kenyans.
- Rejecting a proposal to move essential items such as vaccines, medicines and veterinary medicines from a zero-rated category to tax exempt. (In the case of VAT exemption, producers could not reclaim input VAT and would have likely passed the cost onto consumers, leading to an increase in the cost of medicine in the middle of a pandemic.)
- Increasing the proposed threshold for small businesses to start paying turnover tax from Ksh 500,000 to Ksh 1 million, to benefit more of the most vulnerable businesses in the country.
…but some policies deserved more debate
Unfortunately, some of the government’s tax measures have received less scrutiny and were not as targeted as they could have been. The individual income tax exemption (known in Kenya as personal relief) was increased by 70 percent in 2020, from Ksh 16,896 to Ksh 28,800 per year (from roughly US$157 to US$267 at current depreciated rates).
On the surface, this is a progressive policy, as it means that those in the lowest tier of income taxpayers will benefit the most. But these benefits will accrue primarily to a relatively limited low-wage formal sector workforce. The majority of Kenyans do not pay income tax. According to the Economic Survey 2019, over 80 percent of employment in Kenya is in the informal sector. Only about 20 percent of the nation’s 17.8 million workers filed returns in 2018, and many of these were nil returns (they paid no tax).
More importantly, the cut in income tax rates also reduced the top marginal rate from 30 percent to 25 percent. The logic of this move is somewhat unclear. While Kenya’s marginal income tax rate bands are compressed, such that the top rate kicks in at Ksh 688,000, just below the average annual wage level of Ksh 778,000, those with the highest wages will still benefit the most from this relief measure. For example, in sectors such as energy or finance, the average annual wage is close to Ksh 2 million a year. Higher income workers in these sectors have most of their income taxed at the top rate, and thus benefit more when it is dropped. A financial worker with an average annual income of Ksh 1.95 million, will save Ksh 63,000 in tax in 2020, or about 3 percent of gross income, while a worker that earns the average salary will save just Ksh 4,500, or less than 1 percent of gross income.
The government might have considered modifying the compressed marginal rate structure in Kenya to make it more progressive. For instance, one possibility would be to raise the threshold for the top bracket, so that those with the highest incomes would still face a 30 percent top rate. Or it could have introduced a solidarity surcharge on high-income filers, as recommended by the IMF. Workers who suffer the most are those who lose their jobs and see a drop in their income; in a well-structured income tax system, a worker with declining income will face declining marginal rates automatically. To the extent this is not the case in Kenya, this is again a good motivation for reform.
More concerning is the government’s decrease in the corporate income tax rate from 30 to 25 percent. This is likely to benefit more established and wealthier companies, as well as wealthy citizens that have set up corporations to manage their wealth.
In addition to income tax, changes to business turnover tax deserve a second look
Another area that is not as progressive as it might initially appear concerns the turnover tax, where the government applied the same strategy as with income tax: a higher exemption, coupled with reduced rate at the top. A turnover tax on gross receipts is intended to facilitate tax payments for small companies that may find it challenging to file corporate income tax. The tradeoff with such taxes globally is that they charge a lower rate on revenue, as opposed to a higher rate on profits (which are more complex to calculate and document). Turnover tax is justified on the principle that it encourages gradual formalization of small and medium sized companies; it is intended as a kind of way station in scenarios of high informality and low administrative capacity in both the private and public sector.
Until the crisis, Kenya allowed small or medium-sized businesses with an annual turnover of less than Ksh 5 million (just under $50,000) to pay the turnover tax rather than filing corporate income tax. As part of the government’s COVID response, the threshold for turnover tax has been raised to Ksh 50 million, while those with turnover below Ksh 1 million are exempt (with the exemption increased by Parliament as noted above). The turnover tax rate was also reduced from 3 to 1 percent.
The higher exemption at the bottom seems reasonable and equitable: the vast majority of micro/small/medium enterprises in Kenya (those with less than 100 employees) had annual turnover of less than Ksh 1 million, according to a 2016 KNBS report. These companies are vulnerable to economic shocks, as they serve mainly individual consumers, and they provide a large share of Kenya’s total employment.
In contrast, the increase in the maximum threshold to Ksh 50 million directly undermines one of the goals of a turnover tax: it encourages companies who filed corporate income tax in 2019 with turnover between Ksh 5 and 50 million to revert to a presumptive tax. According to KNBS data from 2017, 40 percent of formal businesses in Kenya had turnover in this range. While the IMF recommends reducing taxes on small businesses during the crisis, it also recommends ensuring that larger business that can pay tax continue to do so. As with income tax, there is also an unfortunate result of the lack of bands: a company with turnover of Ksh 2 million pays the same rate of tax as a company with a turnover of Ksh 49 million. Once again, as with income tax, if a company’s turnover drops sharply, it will automatically pay less in tax. Companies that continue to maintain or increase their turnover should not necessarily receive tax relief.
How much revenue is at stake here? The Parliamentary Budget Office estimates that the reduction in income tax at the top will cost about Ksh 7 billion in 2019/20. The same report estimates a revenue loss for the reduction in turnover tax from 3 to 1 percent, but not for the increase in the threshold. A bigger revenue loss will come from the reduction in corporate income tax rate from 30 to 25 percent, which will cost Ksh 46 billion. While we lack full information about the cost of these measures, and indeed do not know how long they are likely to be in place, clearly reductions for wealthier income earners and larger businesses are an important source of revenue loss.
We have only examined a few areas of Kenya’s tax response to COVID-19 here, and a full assessment of the equity of the government’s response requires a comprehensive review of both revenue and spending policies, which is beyond the scope of this brief analysis. Nevertheless, our limited investigation raises important questions about the logic and equity of the government’s tax response. While we applaud useful exemptions at the bottom, these are coupled with reductions at the top that are less progressive and require further justification. Government might consider better targeted tax policies given limited resources.