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    Design and Performance of Kenyas Tax System:An Inequality PerspectiveBernadette Wanjala13Abstract

    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.

    1I acknowledge review comments by Prof. Francis Mwega, Prof. Terry Ryan, Dr. Mbui Wagacha, Mr. NjeruKirira and Mr. Jocelyn Ogai.

  • Readings on Inequality in Kenya: Sectoral Dynamics and Perspectives58

    2 Even though these principles (equity, efficiency and simplicity) are either complementary or tradeoffs.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 morerapidly than those for the rest of the society (Vandemoortele, 2004).

    Introduction

    Governments need money. Modern governments need lots of money. Howthey get this money and whom they take it from are two of the most difficultpolitical issues faced in any modern political economy (Steinmo, 1993 asquoted by Hardiman, 2004)

    From the mediaeval times, political authority has been used to raise financesfor 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 revenueto fund government operations; (ii) to assist in the redistribution of wealth orincome; and (iii) to encourage or discourage certain activities through the use oftax provisions (Karingi and Wanjala, 2005). In addition to the above objectives,taxation can also be used as a stabilization tool, whereby various instruments areadjusted depending on the economic situation of the country. The extent to whichthese objectives are met differs from country to country.

    There are several principles that guide tax policy. The most commonly citedprinciples are adequacy, equity, exportability, neutrality and simplicity. Neutralityimplies that imposing a tax does not distort economic decisions. This is one of thestrong arguments for imposing sales tax. Simplicity implies that the tax collectionand assessment system does not impose costs greater than the revenue raised, andthe 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. Exportabilityrefers to the extent to which taxes are paid for by non-residents, for example anexport tax. This is not an important aspect of Kenyas tax system.

    The principle of equity is the main concern of this Chapter.2 A tax system isequitable if it is fair. There are two measures of equityhorizontal 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 aswage-earners) more harshly than another (such as investors) are not equitable.Income tax is an example of this disparity. Progressivity and regressivity areunderlying concepts under vertical equity, which are defined in terms of welfarepositions.3 Regressive taxes require lower-income families to pay a greaterpercentage of their income in tax than upper-income families. The classic regressivetax is a sales tax; this is why some governments zero-rate basic commodities as ameans of making the system more pro-poor.4 The sales tax in most cases has beenapplied as a uniform commodity tax and excludes leisure, which is one of thecommodities consumed by economic agents, thereby impacting on resourceallocation.

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    At firm level, failure to take into account the different distributional channelscan also discriminate against firms that undertake more distributional functionsafter the tax imposition point. Progressive taxes require upper-income families topay a larger share of their income in taxes than lower-income families. The classicprogressive tax is income tax. Proportional taxes assess each taxpayer equally andare, therefore, considered bad. Adam Smith is one of the early proponents ofprogressive taxation:

    The subjects of every state ought to contribute towards the support of thegovernment, as nearly as possible, in proportion to their respective abilities;that is, in proportion to the revenue which they respectively enjoy underthe protection of the state (The Wealth of Nations, as quoted in BritannicaEncyclopedia).

    This implies that taxes should be based on the individuals ability to pay, knownas the ability-to-pay principle, and the benefit principle, the idea that there shouldbe some equivalence between what the individual pays and the benefits one derivesfrom governmental activities. However, it is argued that horizontal equity is asubordinate of vertical equity, and the two concepts, therefore, go hand in hand.These principles of taxation are well known but the practice has deviated from theprinciples and greatly varies across countries (Thirsk, 1997).

    One of the roles of the state is to ensure an equitable distribution of income andwell-being of its citizens. This can be pursued through a more equitable tax systemin addition to other policy instruments such as expenditure policies. The KenyanGovernment has over time implemented several measures (both through taxationand expenditure) to aid in income redistribution and consequently poverty andinequality reduction. Despite these attempts, inequality continues to be one ofKenyas biggest development challenges. The 10 percent richest households controlmore than 42 percent of incomes, while the poorest 10 percent control 0.76 percentof income (SID, 2004). Inequality matters for both poverty reduction and growth.The ability of a country to grow and reduce poverty largely depends on thedistributional impact of the targeted fiscal policy initiatives. As acknowledged inthe Economic Recovery Strategy (ERS), Kenyas tax system is depicted as complexand cumbersome, faced with low compliance, uneven and unfair taxes, and a narrowtax base with very high tax rate dispersions with respect to trade. Therefore, usingthe tax system to achieve redistribution of income remains a challenge.

    The distribution of tax burden and the effect of taxes on inequality is at thecentre of public finance debate. A better understanding of the distribution of taxesis important in formulation and assessment of tax systems. Public discourse on taxpolicy focuses on who gains and who loses from a proposed tax measure. However,information on inequality and progressivity of a tax measure is in most cases lackingor inadequate. This study intends to fill this knowledge gap and provide advice onwhat constitutes a fair tax system.

    Design and performance of Kenyas tax system: An inequality perspective

  • Readings on Inequality in Kenya: Sectoral Dynamics and Perspectives60

    The questions arising are:

    How has the Kenyan tax system evolved over time, and to what extent havethe reforms aided in achieving an equitable distribution of income?

    To what extent does greater progressivity in the rate schedule for personaltaxes contribute to increases in progressivity and inequality reduction?

    How do indirect taxes on consumption impact on the distribution of income?

    What are the implications of shifting reliance from income taxes towardsconsumption taxes?

    Taxation, Progressivity and Inequality: Concept andMethodology

    In practice, there are two fundamental concerns in public finance: who has thelegal liability of a tax (statutory burden) and; who bears the final/ultimate burdenof the tax (the economic incidence of the tax). It is through these concerns that taxpolicy can be used to achieve redistribution objectives. Tax burden can be shiftedto other agents mainly by altering economic behaviour through changes in prices.The de

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