Essays on the Size of Kenya’s Informal Sector, Tax Productivity and Optimal Tax Ratio

Abstract

The role of a sound tax system is yielding enough tax revenue. The ability of a tax system to raise adequate tax revenue directly influences the size of public goods provided by a given country‟s government. Kenya‟s tax revenue has recently failed to match public expenditure. This has resulted in a continued widening of the budget deficit from 4.2 percent of Gross Domestic Product (GDP) in 2014 to 7.8 percent in 2020. This failure to raise adequate tax revenue may be linked to Kenya‟s informal sector that is substantial in size, which in turn affects tax revenue, unresponsive tax system to GDP growth and tax ratio that is not optimal. However, these concepts are yet to be examined using Kenyan data. This thesis therefore seeks to fill this knowledge gap. The objectives of the thesis are to estimate the effect of the informal sector‟s size on tax revenue, estimate tax productivity of tax reforms, and estimate the optimal tax ratio in Kenya. The novelty of the study findings arises from the separation of informal sector‟s GDP from recorded country‟s GDP in the estimation of tax productivity of tax reforms using ARDL, VECM and VAR models. This study uses annual time series data for 1970 and 2018 period. The study established that Kenya‟s informal sector accounts for about 32 percent of national income. In estimating the effects the informal sector has on size of tax revenue, the study finds an inverse and statistically significant link between the two. This means that the informal sector negatively influences tax revenue in Kenya. In estimating the tax productivity of Kenya‟s tax reforms, a buoyancy coefficient of greater than one is found. For tax elasticity, the study finds a coefficient of less than a unit. These findings show that Kenya‟s tax system responds slowly to changes in GDP. The discretionary tax reforms are found to be effective in increasing tax revenue. Further, the study finds an optimal tax ratio of 15.87 percent of GDP. From the thesis‟s findings, a number of policy implications have been made. First, since Kenya‟s informal sector might largely linked to poor governance, a good policy package could assist streamline regulatory and tax frameworks while at the same time improve efficiency of public revenue mobilization. In addition, there is need for regulatory enforcement that includes strengthening of public service delivery aimed at boosting tax morale. Further, Government of Kenya should encourage cashless transactions to track incomes earned by businesses in Kenya. Thirdly, to ensure the tax system responds to changes in GDP, the Government needs to embrace constant review of the tax system to remove some tax exemptions that may erode the effective tax base, widen tax coverage, and adjust the tax rate for inflation regularly. Fourthly, the Government should aim to reduce the tax ratio to attain an optimal tax ratio. This can be achieved by tapping more tax from the informal sector and reviewing current tax rates downwards