Policy elites are not blind to economic realities


Empirical research has shown that tax compliance, guided by sound analytics is the silver bullet in unlocking the revenue potential in developing economics.

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In Business Daily on May 24, 2024, Jaindi Kisero, a prominent journalist, wrote an insightful piece touching on tax. The article's heading was captivating: Policy elites blind to tax burden. The gentleman writes very well, I have enjoyed reading his articles for a couple of years.

In his article today, several postulations arise which can be tested as a hypothesis empirically. As an economist, and an analyst in public policy circles, I felt obliged to clear up on some of the aspects.

The first assertion was that tax effort statistic was the guiding metric of taxation.

Well, tax effort is an important comparison metric across various jurisdictions. It gauges your capability as a country to raise revenue given the size of your economy. Raising your tax effort to the expected level e.g. 20 percent doesn’t translate to increasing the tax burden always, times it is a reflection of increasing tax compliance.

When you look at South Africa where the tax effort is about 25 percent, one striking difference with our economy, other than income levels, is the size of informality. Informality implies a sizeable chuck of economic activity that is taxable but not in the tax net.

In Kenya, statistics show employment in the informal segment is 80 percent. If this component was in the tax net, the tax effort could grow significantly. With only compliance measures, especially leveraging technology and relooking at payment systems, such a segment can be looped into the tax base without necessarily raising the tax burden.

In guiding on how to increase tax effort, tax gap statistics have been very useful. Thorough research and statistical analysis goes into generating these numbers.

Tax gap is the difference between potential revenue - that can be collected compared to what the revenue agency is collecting now per tax stream. Broadly, such gaps enable policy makers to foresee the possibility of closing the gaps without necessarily changing the tax structure.

Empirical research has shown that tax compliance, guided by sound analytics is the silver bullet in unlocking the revenue potential in developing economics. In addition, relooking at the payment systems, reducing cash based transactions is a quick way of ensuring the definite tax base is observable.

Recently, Colombia surprised policy makers in a benchmarking exercise when it was confirmed that their efforts to deal with informal sector was based on payment systems. In 1980s, they realized the need to formalise by eliminating cash and using electronic cards for payments. That way, you will have a clear view of all informal transactions.

The article further touched on tax incentives. Tax incentives are concessions that allow some taxpayers to enjoy tax breaks. As such, the government incentivises investments, and exports, or even cushions low-income segments from high price effects.

Over time, the revenue forgone due to these concessions has grown significantly. The National Treasury monitors expenditures on an annual basis and publishes a report that is open to public participation.

The research question has been, do tax incentives impact target variables? Most evidence points to the contrary. Other than the effect of zero-rating exports that translates to competitive international prices, internally most incentives are redundant or have a trivial effect.

Investment surveys done on the effect of incentives in Kenya shocked most of us. Investors consider a list of factors ranging from macroeconomic to political stability.

Tax incentives rank 11th on the list.

Further analysis of the impact of capital expenditures on investments is not impressive. Why would capital expenditure policies be used when most of the firms are labor-intensive? That is the policy thinking around rationalizing tax expenditure. Sound policy analysis would consider, the possibility of eliminating redundant incentives, and perhaps using the buffer to reduce tax rates across other spectrums.

One will note that in the article, is that taxation is a significant driver of final product prices. This is part of it but look at the recent supply chain disruptions, external shocks, and inherent inflation among other factors are culprits as well. However, the critical consideration is, do you think reducing the rates translates to a direct fall in the prices, not always so.

The print media may need to dig deeper into economic matters and portray the true state of affairs. When you have a historically large debt burden, a constrained revenue collection capability, and diverse funding needs, you can’t escape fiscal sustainability issues.

The only way to reverse the economy to a sustainable path is fiscal consolidation, particularly by creating a primary balance surplus. Fiscal consolidation requires a stealth but keen balancing. There are trade-offs. Fiscal consolidation is a painful process, but if well managed it bears fruits in the long run.

There is a political price to pay too. In my view, the president is committed to addressing these fiscal affairs challenges head-on, so far, the results are impressive but it is a difficult path. For instance, most subsidies are removed in fiscal adjustment programs. Obviously, prices adjust upwards immediately which raises political temperatures.

Also, wage cuts and freezing social transfers are known to be politically very costly. A times, even taxing basic commodities is a perfect policy.

In some sense, increasing basic commodity prices marginally to close a big revenue gap, and avoid costly external financing, with long-term implications is a better policy. These are critical considerations as the fiscal affairs debate takes a constructive move.

Cyrus Muthuka Mutuku is a research economist and a policy analyst

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