Policy shift is imperative to net more taxpayers in informal sector

According to the Kenya National Bureau of Statistics’ Economic Survey 2023, as of May 2023, over 83% of Kenya’s working population is employed in the informal sector. Many informal businesses are borne out of necessity, by creative but marginalised people who may not have viable alternatives. However, arguably, there could be some thriving businesses that deliberately avoid formalization in order to evade tax. Studies have shown that attempts by developing nations to bring the informal sector to taxation have yielded less than satisfactory results with most countries reporting less than 1% of their total tax revenue from the informal sector, despite having a large informal economy. 

While National Treasury does not report revenues from informal sector separately, it is well known that the Government’s many attempts to bring these hard-to-tax businesses into the net have not borne much fruit. Perhaps it’s time the government considers other approaches to achieve this objective!

Attempts by the government to tax the informal sector

Over the years, the Government has attempted to introduce simplified tax regimes targeted towards the informal sector. Turnover Tax of 3% of gross turnover was introduced in 2007 for businesses with annual sales of between KES 500,000 and 5 million KES. Excluded from this tax were registered companies and businesses providing professional services. In 2020 the turnover tax rate was reduced to 1% in the wake of the COVID 19 pandemic. The threshold for eligibility was also enhanced to include incorporated companies with a turnover between KES 1million and 50million. Most recently, the Finance Bill 2023 proposes to revise the rate back to 3% effective with effect from 1 July 2023. The bill has also proposed to revise the threshold for turnover to a range of KES 500,000 to KES 15million.

In 2019, the government introduced presumptive income tax at a rate of 15% per annum on the cost of business permits issued by county governments. However, the tax was criticized for being regressive as it was pegged on the value of business permits without any reference to income. Lack of cooperation from the County governments in administering the tax may have also contributed to its failure resulting to its abolishment in 2020. An earlier form of presumptive tax at 3.5% on turnover from the sale of select agricultural products was also abolished for similar reasons. Advance tax was also introduced in the hope of netting public service vehicles (“PSVs”) and other commercial vehicle owners and operators. Currently the tax is applicable at varying rates depending on passenger capacity and/or vehicle mass. The Finance Bill 2023 proposes to double the rates of advance tax from January 2024.

Given the frequent changes in law, it appears that Kenya so far seems unable to find an optimally designed taxation regime that would serve to effectively bring the informal sector into the tax net. Expanding the tax base by netting this sector appears an elusive goal.

Key challenges in taxing the informal sector

One of the challenges may be the lack of data about these enterprises on the basis of which meaningful planning can be effected. A recent report by the World Bank indicates that 94% of micro, small and medium enterprises (MSMEs) are unlicensed. This makes it difficult for the government to track the magnitude of business transactions in this sector and accurately measure its contribution to Kenya’s GDP.

There is also a general lack of financial literacy and awareness of tax obligations. Majority of enterprises in this sector do not maintain adequate records and may not be able to assess the performance of their businesses. Without proper records, the revenue authority is unable to ascertain the taxes due from these entities. 

Moreover, a lot of transactions in this sector are cash and mobile money based, and do not require one to have a Personal Identification Number (PIN) or to open a bank account. Traders may also fail to voluntarily register for tax where they feel that service delivery by the Government is disproportionate to the taxes imposed. Others may blatantly avoid paying tax knowing they can get away with it. 

Notably, the Kenya Revenue Authority has made significant strides in addressing the administration costs of turnover tax by improving the iTax user experience as well as creating awareness through continuous taxpayer education. Despite this, compliance remains low which may be indicative that either the targeted taxpayers still perceive compliance to be costly or that tax morale is very low. 

Proposed approach

In my view, it appears like the best outcome may come from a shift towards policy reforms that incentivise small businesses to become formalised. The government should consider offering effective tax incentives including reliefs, deductions or exemptions for specified periods until a small business has had time to grow thus easing their financial burden during those initial stages. The KRA may also consider appointing agents such as trade unions and SACCOs to assist with the registration of their members given their extended reach at the grassroot level. 

One initiative that appears promising in promoting formalisation is the Hustler Fund which was launched in November 2022. The Fund provides individuals and groups with easy and ready access to finance and seed capital, while aiming to mobilize them to formally register their businesses, obtain valid KRA PINs and evolve small groups and community-based organizations into registered SACCOS. Though still in its infancy stages, the Hustler Fund, if well managed may prove to be a useful tool in incentivizing small businesses to formalize. 

The government through the Micro and Small Enterprises Authority (MSEA) has also increased access to public procurement opportunities by deliberately setting aside projects to be supplied by MSMEs and by simplifying the bidding requirements and processes to encourage registered entities to participate. It is hoped that small businesses will be encouraged to formalize given the incentive to conduct business with the government.  

While the above proposed measures are a step in the right direction, meaningful gains towards shoring up tax revenues by including the informal economy can neither be rushed nor achieved in the short term.  To truly widen and deepen the country’s tax base, medium and long-term plans supported by tax policy must be established to increase the share of the formal sector in the economy, even as the government tries to net the informal sector into the tax net. An impact assessment of the various initiatives by the government should be conducted to obtain data on businesses formally registered as a result of direct government incentivisation and the tax revenues resulting therefrom. Only then can we know whether the objective of increasing tax contribution through formalization are being achieved. On the other hand, the government must in turn be seen to be accountable for the revenue it collects and improve service delivery to the people it taxes. This would serve to enhance the general public’s tax morale. 

Michael Othieno is a tax consultant at Deloitte East Africa. The views presented are his own and do not necessarily represent those of Deloitte. He can be reached mothieno@deloitte.co.ke