Will a consumption-based tax finally net informal economy?

An illustration of over-taxation. [Getty Images]

During the 2018-2019 Budget Statement reading, then National Treasury Cabinet Secretary Henry Rotich detailed how the turnover tax introduced in 2006 had become unsuccessful in netting the informal economy.

He told the country that compliance levels had become low due to the profile of the sector and tabled a proposal to deal with these ghost enterprises.

“I propose to amend the Income Tax Act to replace the turnover tax with a presumptive tax based on the business permit or trading license fees at a rate of fifteen percent in order to ensure that the sector contributes towards the economic agenda of the country,” he said.

It marks yet another one of the futile attempts to net the informal economy who for long have always outwitted the taxman.   

As such, the burden has always been placed on formal business and workers, who Zacchaeus can easily track.  

But a proposal by CPF Financial Services Managing Director Hosea Kili on tax reforms to the National Dialogue Committee seems to have a solution to this: tax consumption instead of income.

Paper trail

One of the arguments that supports Mr Kili’s proposal on tax reforms is that a big chunk of the economy still operates in cash, a typical phenomenon for an informal driven economy.

About 80 per cent, he says, with 15 million documented informal workers against just three million formal counterparts.

Such makes the paper trail of this cash flow hard to trace since it does not go through the formal financial systems like banks, Saccos, microfinances and mobile money where it would otherwise be subjected to excise duty, yet this money does play a role in the economy by producing or purchasing goods or services contributing to the country’s Sh13 trillion Gross Domestic product (GDP).  

For this reason, a consumption tax will play a role in ensuring the government collects what is owed to them.

A May 2006 working paper by the International Studies Program titled Is VAT the best way to impose a general consumption tax in developing countries? explores this.

“Under any form of consumption tax, those who operate entirely in the cash economy may remain largely unknown to the tax authorities. Even these ‘ghosts’, however, will pay some tax to the extent they purchase either consumer goods and services or inputs for their productive activities from the taxed sector,” the paper reads.

The paper illustrates that when formal sector entities trade with their partners of similar status, they are on the radar or the taxman.

But if informal trade with informal, then they are outside the tax system yet they are profiting from producing goods and services. If these informal or non-registered enterprises, purchase these goods and services from registered ones, they will encounter some form of VAT, which indirectly makes them taxpayers.

“Both theory and experience suggest on the whole that a VAT is – other things such as ‘entry levels’ to the system being equal - more likely than other forms of general sales tax to reduce than increase tax evasion,” the paper states.

This Pay As You Spend (PAYS) tax model is poised to collect sh6.3 trillion in revenue for the government according to extrapolations by Mr Kili. This is from the average Sh2 trillion Kenya Revenue Authority (KRA) collects annually.

This system will work by registering every citizen for tax and special funds. When you transact for goods and services, you will then be paying the price plus 16 per cent transactional tax plus save as you spend.

This amount will be deposited to a consolidated fund where it will automatically be allocated to various accounts and funds.  

Fair distribution

Kili says one of the benefits of this proposed tax system is fair distribution of the tax burden in line with Article 201(b)(i) of the Constitution and equity in tax payment between the rich and the poor.

However, Oxford Business Group, which offers market intelligence and consultancy services for various sectors, in an analysis of the possibility of a consumption tax system in Kenya, points out that such may be to the disadvantage of the poor.

It however threw its weight behind a reformed consumption tax system for the country.

“In Kenya, consumption tax reform could earn major revenues for the government, providing reforms do not distort consumer spending habits,” reads the analysis. “However, an intensive consumption-based tax system would significantly affect low-income earners, who spend the bulk of their income on necessities such as food, clothing and rent.” Titled Kenya Debates Introducing Consumption Taxes to offset noncompliance, the analysis notes that Kenya is a largely informal economy that is characterised by tax noncompliance.

It adds that in an ideal situation, consumption taxes reduce the need to directly tax business earnings, including net profits, interests and dividends.

“In addition, they can widen the tax base and bring in the informal economy, consequently leading to increased tax collections,” reads the analysis that looked into the 2018/2019 Budget Statement.

Features of this tax model, the proposal explains, will consolidate all taxes into one levied at 16 per cent. This will replace VAT, Excise Duty, withholding, county taxes and other levies, and income tax.

VAT and Excise Duty are the two main taxes that are consumption based. 

Owing to the possible detrimental effect on the poor, the proposal has that it shall not be levied on basic goods to avoid repression and lack of equity between the rich and poor.

“Shall be levied at source, that is, on all transaction for goods and services and works for all citizens,” the proposal reads.