Informal Sector and Taxation in Kenya: Issues and Policy Options

Presentation during a Public Forum

Held at

Nairobi Sarova Hotel - Nairobi

3rd May 2012

Martin M. Masinde

1

Presentation Outline

1.0 Introduction

2.0. The Informal Sector: An Overview

3.0. Approaches for Revenue Collection Within the Informal

Sector

4.0. Existing Opportunities for Revenue Collection in the

Informal Sector

5.0. Policy Considerations and Options

2

The Informal Sector : An overview

Comprises of activities primarily of small traders involved in such

activities as the selling of second-hand clothes, shoe shinning,

food selling and repair and construction; operating mainly from

the streets of the main urban centers.

It can also be described as any activity generating income and

profits, though on a small scale, uses simple skills, is dynamic

and not tied to regulation of the activities.

Informal Sector is referred to as jua kali in Kenya

Operates on small-scale, locally and at a subsistence level, have

fewer employees (especially home-based enterprises), operate

for a shorter period, and have poor access to water and

electricity and few sell outside the establishments where the

entrepreneurs live.

3

Informal Sector employment: Overview contribution to

GDP in Kenya

The taxation of the Informal Sector is an important topic for policy

makers, as the sector makes up majority of businesses (Small

&Medium Enterprises) and typically account for the bulk of

employment.

The First 1993 MSE baseline survey revealed that there were

approximately 910, 000 MSEs employing up to 2 million people. The

second MSE baseline survey (1995) estimated the size of the MSE

sector at 708, 000 enterprises employing up to 1. 2 million people.

Compared to the other sectors of the economy, the contribution of

the MSE sector to the country’s Gross Domestic Product (GDP)

increased from 13.8% in 1993 to over 18% in 1999 (Sessional Paper

No. 2 of 2005).

According to the Kenya Economic Report, 2009, MSEs sector

accounts for 87 per cent of all new jobs created and absorbs about

77 percent of total number of employees in Kenya.

4

Informal Sector employment: Overview contribution to

GDP in Kenya (Cont’d)

The sector generates 18.4 percent of GDP and it is estimated

that 74.8 per cent of all businesses in the country fall within SME

The International Tax Dialogue (ITD) Global Conference on

taxation of small and medium enterprises held in Buenos Aires,

Argentina, 17 – 19 October 2007 recognised that SMEs play a

prominent role in all economies.

They are important to the economy and they are important to tax

policymakers and administrators.

The large numbers of SMEs, their high turnover rates and their

sheer diversity present challenges to all administrations.

For SMEs, key considerations are to minimise administrative

burden while ensuring compliance, including considering the

drivers and impacts of operating in the informal economy.

5

Informal Sector tax evasion

Informal Sector tax evasion is driven generally by a perception

that the tax burden is too high, poses a number of problems to

tax systems, raising difficult questions over how tax policies and

tax administration may influence tax compliance incentives and

behaviour.

The compliance tax burden on the Informal Sector may be high

relative to that for large companies (higher unit cost in relation to

turnover)

Further, the cost of complying with a given set of tax

rules/regulations is generally higher for the Informal Sector as a

percentage of turnover or profit.

In theory, a taxpayer’s incentive to comply with a tax system

depends on an assessment of the relative benefits and costs of

complying versus not complying

6

Common obstacles to taxing Informal Sector include

It is easy for small businesses to remain outside the tax net, i.e.

they are inconspicuous to the tax administration.

They are largely cash businesses – inadequate accounting

records and audit trail.

Complicated tax systems and numerous processes (licensing

etc.) make it difficult and expensive for start-up firms to act in

good faith.

In developing economies, small businesses are rarely excluded

from the tax base but are rarely properly attended to by the tax

administration.

Presumptive taxes proliferate and are rarely fixed or regularly

adjusted – these regimes become stagnant pools often beneficial

to small business for all the wrong reasons.

7

Reasons for non compliance in the informal Sector

Poor management and internal control practices – many are

merely trying to make ends meet, thus are essentially

survivalists.

Informal approach to establishment, operation and dissolution

creates an ease of mobility making it difficult for the tax

administration to keep up-to-date.

Cash-based economies – inadequate accounting records and

audit trails.

Compliance costs are much higher relative to larger business

operations.

Small businesses have limited resources and technical capacity.

Often the priority of a tax administration is to focus on large

taxpayers because of the high delinquency rate and low revenue

yields associated with small businesses with very little

enforcement action. This only encourages non-compliance.

8

Kenya’s Revenue Capacity and Tax Effort

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Kenya’s Revenue Capacity and Tax Effort

Assuming that tax effort is adjusted for various growth

rates as a proxy for the improved tax effort, in the years

running up to 2009/2010, Kenya lost revenue worth

Kshs. 275 billion

This corresponds to an average revenue effort of 35.9

per cent when revenue capacity is compared to revenue

losses.

This means that this sum of potential revenues remain

uncollected.

Correlation results indicate a strong correlation between

tax collection and economic growth

10

Estimates of the size of the underground

economy

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Estimates of the size of the underground economy

The Government lost Kshs. 63.5 billion, Kshs. 69.73 billion,

and Kshs. 79.273 billion in 2006, 2007, and 2008,

respectively.

In other words, in 2008, by bringing the underground economy

fully into the tax net, the government could have increased the

tax base by approximately 7.66 percentage points,

translating to revenue worth Kshs.79.3 billion.

If the underground economy remains untaxed, the

government will continue losing billions of shillings in terms of

revenue and as more people move into the informal sector to

escape the burdensome taxation, it will become increasingly

difficult for the government to hit its revenue targets.

12

Informal Sector: Introduction of Turnover Tax (TOT) in

Kenya

Pressure to generate sufficient revenue to meet expenditure

needs amid dwindling customs revenues.

A proposal was debated by the government in 2004/05 to

increase VAT threshold from Kshs.3m to Kshs.5m.

The total number of taxpayers envisaged to have been in that

bracket was approximately 66,000. Out of this number 52,000

were falling below Kshs.5m.

In the Finance Bill 2007 and Turnover tax was born.

13

Informal Sector: Rationale and performance of

Turnover Tax (TOT) in Kenya

Most of the micro and small traders either keep

incomplete business records or do not keep any record

at all.

Attributed to low levels of education attained by majority

of the traders.

To enhance their tax compliance, there is need to isolate

the micro and small traders from the current tax regime

in accordance with international best practice.

The objective of introducing Turnover tax (TOT) in Kenya

was geared towards bringing the informal sector into the

tax net and to simplify processes for the small and micro-

enterprises by: simplifying tax procedures, simplifying tax

computation and by simplifying record keeping.

14

Informal Sector: Rationale and performance of

Turnover Tax (TOT) in Kenya (Cont’d.)

It was decided that the VAT threshold be raised from the

previous threshold of Kshs.3 million to Kshs.5 million such that

85% of the non-designated businesses whose annual turnover

fall below Kshs.5million of the new threshold.

Turnover-based tax regime at 3% of the gross sales turnover per

annum without considering any over head expenses. The

performance of TOT revenue has been below average in most

months since its inception.

In year 2008/09, TOT performed at 31% with a total of Kshs. 136

Million against a set target of Kshs. 442 Million. From beginning

of 2009/10, the performance of the TOT is above average but on

a declining trend.

15

Informal Sector: Rationale and performance of

Turnover Tax (TOT) in Kenya (Cont’d.)

On TOT recruitments, a total of 18,369 taxpayers have

been recruited from April 2008 to Feb 2010, the number

is likely to be larger now.....

The performance rate has on average been below 50%.

16

17

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Kshs Million

2007/08 2008/09 2009/10

Actual Target Per. Rate Actual Target Per. Rate Actual Target Per. Rate

July 25 93 27% 21 36 57%

August 2 6 33% 2.4 3 83%

September 4 6 65% 2 6 42%

October 27 93 29% 23 39 58%

November 2 6 27% 3 3 111%

December 4 6 60% 6 6 99%

January 35 102 34% 22 51 43%

February 2 9 26% 3 3 100%

March 3 6 51%

April 20 37 54% 23 96 24%

May 5 37 15% 7 9 77%

June 3 37 8% 3 9 29%

Total 28 111 25% 136 442 31% 57 92

Non –compliant turnover taxpayers Taxpayers who fail to keep records.

Taxpayers who fail to submit their Turnover

Tax quarterly returns

[TOT 3].

Taxpayers whose turnover is below Kshs 5

million and deliberately avoid registration.

Taxpayers who falsify records.

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Penalties, fines and interest A TOT Taxpayer who fails to file a return shall be liable

to a default penalty of Kshs. 2,000/=.

A TOT Taxpayer who fails to pay the tax on the due date

shall be liable to pay a late payment compounded

interest of 2% per month or any part thereof.

A TOT Taxpayer, who knowingly submits an incorrect

return, will be charged double the difference between the

normal tax chargeable on the basis of his return and the

actual tax due.

A TOT Taxpayer who fails to keep records which in the

opinion of the Commissioner is necessary for the

determination of his turnover, shall be liable to a penalty

not exceeding Kshs.20,000/.

19

Policy Considerations

Under what conditions can the Informal Sector make

their biggest potential contribution to a healthy

economy?

What policy, including tax policy, can make a

considerable difference on how well the SME sector

fulfils its potential role in contributing to a healthy

economy.

Informal Sector is often disadvantaged vis a vis large

firms by market imperfections, especially in the capital

and product goods markets.

Since most market imperfections cannot be fully, often

not even partially, removed, policy analysis must be

carried out in the context of the “ROLE OF STATE”.

20

Policy Considerations (Cont’d.)

Areas to focus for policy:

Labour Legislation.

The capital market, which is almost by definition very

imperfect.

Incentive to pay tax ??? Prudent Financial

Management

Tax policy: Negative incentive effects on each of SME

creation, output, and labour intensity

21

Approaches the govt can use to ensure revenue collection from Informal Sector

A number of approaches have been tried to reduce risk of under-

declaration of business turnover as follows:-

Loans. In the Netherlands lenders limited to financial

institutions and regional development grant institutions receive

tax-free interest income.

Equipment Purchase. In Austria, Micro (Small) businesses

having in excess of 70% of the micro threshold amount that

reinvests profits into the purchase of new equipment are

allowed a 10% reduction to total turnover if the cost of the new

equipment exceeds the 10% reduction to total income.

Audits. It is cost ineffective to audit micro enterprises.

However, to assure compliance, spot inspections have been

implemented in Australia.

22

Approaches the govt can use to ensure revenue collection from Informal Sector (Cont’d.)

Providing incentives for improving recordkeeping. Turnover-based

systems, if well designed, offer a good possibility of providing

specific incentives for improving recordkeeping standards.

Promotion of credit card use: Under-declaration of turnover is much

facilitated in a cash-dominated economy.

Tax invoice lotteries: Introduction of incentives for issuing

receipts. This can be done, for example, in the form of organizing

receipt lotteries.

Some countries have established a legal requirement to use the

banking system for making payments for purchases or services

above a specified amount.

23

Cont’d. Despite the high risk of turnover evasion, the system must be

based on actual and not on presumed turnover. A badly

designed turnover-based system, which does not sufficiently take

into account actual business turnover as a base for calculation of

the presumptive tax burden, in fact turns into a simple patent

system.

A presumptive tax system can create major obstacles to small

business growth if the transition from the presumptive into the

standard taxation regime is costly or complicated. There is need

to:-

Offer some incentives to improve recordkeeping of businesses

in the presumptive system.

Extensive assistance and information campaigns on the

importance and details of recordkeeping.

The possibility to claim and carry forward losses is an

important element of the standard regime, which benefits

MSEs during loss-making periods.

24

Way Forward / Lessons Instead of lumping the TOT tax regime amongst the general Domestic

Revenue, informal sector requires special attention.

Due to the complexity of the sector, there it is urgent to have a “one stop

shop” whereby the entities pay the fair share of taxes at the point of

licensing. A typical example will be to harmonize the registration system

of the Nairobi city council and the KRA database.

Ouma (2007), there is need to improve data capture and have a reliable

database to allow for further analysis of the characteristics of the

underground economy.

Improve bookkeeping among micro and small enterprises by offering

incentives such as application of a lower presumptive tax rate for small

businesses meeting certain recordkeeping standards.

25

Way Forward / Lessons Enhance voluntary compliance by establishing a strong

enforcement.

Educate the small businesses on the importance and details of

book keeping and offer them assistance to improve their

record keeping standards.

Encourage transition from the presumptive to the standard

regime such as by offering the possibility to claim and carry

forward losses which benefits MSEs during loss-making

periods.

Enhance the capacity of the formal sector by offering them with

business counseling, training and reducing their cost of

registration among other incentives aimed at assisting their

businesses to flourish and in turn, drive economic growth and

increase revenue collection 26

THANK YOU &

GOD BLESS

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