Taxing informal sector requires better strategy

It is estimated that the informal sector in Kenya contributes in excess of 35 per cent to the GDP and employs close to 80 per cent of the workforce.

Many studies define the sector as comprising economic activities that are not regulated by laws relating to taxation, labour and environment. It is a significantly important sector.

However, such definitions are misleading and may have driven treasury secretary Henry Rotich to propose presumptive taxation measures for the sector in the 2016/17 Budget estimates.

The debate to tax the sector has been in the cards. At a recent pre-budget workshop, an official from the Kenya Revenue Authority (KRA) presented a paper titled ‘‘Informal Sector and Taxation in Kenya: Issues and Policy Options’’, which estimated that tax losses from the sector amount to between Sh60 billion - Sh80 billion a year.

KRA failed to acknowledge the fact that the informal sector pays taxes indirectly both to the national as well as the local governments.


The blanket condemnation of the sector is therefore unjustified. The introduction of a presumptive taxation method (use of indirect means to ascertain tax liability, which differs from the usual rules based on the taxpayer’s accounts and records) is highly subjective and will hurt not just the informal sector but KRA too.

This is because the method is not the best in fostering tax compliance and the administrative cost may be too much to bear.

By introducing indirect tax assessment methods, KRA is likely to use bank deposits, net worth and sources and application of funds that are all pretty much debatable.

Use of bank deposits to assess tax could discourage banking and hurt money supply. The net worth method would require expert knowledge to assess asset values and it may prove expensive.

Perhaps sources and application of funds may be accurate, but the method requires strict record keeping which is the greatest weakness of small and micro entrepreneurs (SMEs).

Research on the informal economy, for example, including a major work by Peruvian economist, Hernando de Soto’s El otro sendero (1986), that was published in English in 1989 as ‘‘The Other Path’’, argues that excessive regulation in the Peruvian (and other Latin American) economies forced a large part of the economy into informality and thus prevented economic development.

The Kenyan government should not rush into additional regulatory mechanisms until reforms on doing business in the country are complete.

Perhaps the Treasury is not aware that many of the SMEs within Nairobi’s Central Business District spend the better of the day playing hide and seek with county enforcement officials.

Others suffer from political disruptions. They lack sanitary facilities in the many places they operate from and are largely stigmatised as problematic and uncontrollable.

Whereas the informal sector may generally not be monitored for inclusion in the computation of the GDP, the sector has increasingly come under regulation and now greatly contributes indirect tax revenue to the State.

The sector’s role is larger than what the policy makers think. At the minimum, the sector keeps the country stable by providing employment where industry has failed.

The backwards and forward linkages between the informal and formal sectors support many formal industries through ubiquitous distribution mechanisms without which some formal enterprises could collapse.

The majority of SMEs, especially at micro level, are women who are likely to be vulnerable to harassment by tax assessors.

There are creative ways to build a tax compliance culture. Mauritius and China developed an incentive that linked tax payments to lotteries.

A recent study by Deloitte recommended that the Nigerian government use a similar scheme such that tax receipts, such as PAYE, value added tax and withholding tax receipts, could be used as lottery tickets, and taxpayers would have the opportunity to win simply by filing their tax returns and paying the tax due.

The more effective method is to start with a low tax rate for the informal sector and progressively harmonise it with the general taxation method.

This method was effectively used by the Irish government, which introduced a low 12.5 per cent uniform income tax rate and later simplified procedures and regulations.

They succeeded in developing a tax compliance culture. A more creative method is to encourage use of electronic transaction by slowly moving the economy out of cash transactions while building a big data analytic capability.

In the long run it would be easy to estimate tax liability without a protracted fight with a key sector. In effect, Kenya needs a long-term incentive strategy to bring the informal sector into the tax bracket.

It must not just be promoting a culture of tax compliance, but a genuine progressive strategy that encourages enterprise scalability.

The writer is an associate professor at University of Nairobi’s School of Business.