Kenyan tax inducements and economic stabilization: A review
Kenya seems to use tax policy to achieve a stabilization objective. Tax policy in the form of tax cuts, tax credits, and tax expenditures (including deductions, exemptions, reliefs and set offs) have been used all over the world to attain economic stabilization. This short paper takes a look at tax expenditures in the form of deductions and their diminishing and changing role in the macroeconomic environment and recommends an assessment by the government on whether tax credits would be more viable than the current tax expenditures.
Tax policy vs. stabilization:The evolution
Stabilization can be defined as a macroeconomic strategy enacted by governments and central banks to keep economic growth stable along with price levels and unemployment. Professor Musgrave (1959) points out that the stabilization objective seeks to ensure a balance of payment, price level stability and employment. Tax policy was traditionally examined using criterion based on 3 principles which include efficiency, equity and simplicity.
However, after the Great depression of 1929, scholars and law makers reached consensus that tax policy should play a role in economic stabilization, providing governments with an important ‘weapon to forestall recession.’ Griswold, in his book, Cases and Materials on Federal Taxation, listed several objectives of tax policy. He contended that tax policy should play a role in economic stabilization. Musgrave’s classic text on tax policy The Theory of Public Finance: A Study in Political Economy, listed three objectives of public finance one of which is economic stabilization. Similarly, Pechman’s book, Federal Tax Policy, contains an extensive discussion of Stabilization Policy giving second billing to the role of tax policy in promoting economic growth.
However, during the period between the Great depression and the Great recession in 2007, a period sometimes referred to as the ‘Great moderation period’, a consensus developed that fiscal policy (which includes tax policy) was inappropriate for stabilization. It was agreed widely that monetary policy alone could handle the task of stabilizing the economy and there was no need to muck up the tax policy with an unnecessary task. Scholars who had earlier highlighted the importance of tax policy for economic stabilization relegated this macroeconomic perspective of tax policy to the periphery while some entirely ignored the perspective in their latter editions. The exile of macroeconomic perspectives from consideration of tax policy reflected a widespread consensus in favor of examining tax policy from a microeconomic-and not macroeconomic-perspectives.
This perspective too has begun changing. The 2007 Great recession ended the academic consensus in favor of a monetary policy as the sole lever for stabilizing the economy. In the US for instance, many tax policy experts supported tax cuts and tax expenditures (including deductions) explicitly for their stabilization benefits.
The deductions under the second schedule to the Income Tax Act of Kenya
Despite the changing perspectives in the field of academia on the role of tax policy in attaining economic stabilization, tax policy has been used in Kenya and other countries in achieving the stabilization objective and ensuring employment and price level stability. One way through which the Kenyan tax regime does this is through deductions from taxable income some of which are enumerated in the second schedule to the Income Tax Act.
In computing taxable income, individuals and legal persons are permitted to deduct a series of expenditures. The deductions listed in the second schedule to the income tax Act pursuant to section 15(2) (d) generally include deductions in respect of capital expenses on certain industrial buildings; deductions in respect of capital on machinery; deductions on mining machinery; deductions on agricultural land and other farm-works; investment deductions/ allowance and deductions for manufacture under bond in Export processing zones (EPZ) for shipping companies.
In addition, there are other miscellaneous deductions. Under Paragraph G, deductions considered just and reasonable representing the diminution of value of any implements, utensil or similar implement that is not machinery are allowed. Paragraph H allows withdrawals of subscription/annual fee paid by the taxpayer to a trade association or club, which has made election under section 22 for its income to be taxed. Paragraph M allows deduction of income from a mining company while Paragraph N allows deduction of expenditure incurred by a person for purposes of research carried on by him or if that deduction is expended for sum paid to a scientific research institution. Related to this, it allows deductions for a sum paid by a University, college or research institution approved by the commissioner for scientific research related to class of business to which that business belongs.
Why the deductions?
The general purpose of these deductions is to ease the burden of special expenditures that affect a tax paying unit’s ability to pay. They are also meant to encourage certain types of activities (such as home ownership, industrialization, food security, mining, scientific research). In addition, the deductions allow the tax payers to deduct the cost of legitimate business expenses. The role of the specific deductions can be summarized as hereunder.
Firstly, when a deduction of the nature of industrial machinery or building is made, that is meant to encourage industrialization. With an industrialized country, the object of ensuring employment will be addressed and this falls under the larger ambit of economic stabilization.
Also, deductions with respect to investments also act as key incentives to encourage investment by both local and foreign investors. This in turn helps to create employment and provide shock buffers whenever the economy faces shocks (which are stabilization functions). In Kenya it has been argued that despite the 2007-2008 post-election violence and other economic challenges (notably the great recession of 2007), foreign direct investment continued to grow. This was attributable partly to foreign direct investments encouraged by the tax deductions and incentives and to privatization of parastatals. In 2008 for instance, Kenya managed $95.6 million in direct investment which rose to $116.3 million the following year. Foreign direct investments are a key avenue for fighting unemployment and in some cases, price level stability. This has been encouraged through deductions under Paragraph 24 of the Second to the Income Tax Act that deal with investment deductions.
In addition, deductions on expenses incurred in conducting research are desirable in the sense that research brings desirable results that help in attaining a stable economy.
Furthermore, food security and increased export of cash crops is also an important indicator and factor in assessing the economic stability of a nation. By having deductions on expenses on agricultural land and farm-works, the tax policy aims at encouraging agriculture which will not only lead to food supply but will lead to creation of employment and more exports for the exportable cash crops. With more exports, a country’s economic stability is maintained.
Effectiveness of the deductions in achieving the stabilization objective
In spite of the importance of tax deductions and other tax expenditures, there seems to be growing criticism of the use of deductions and other tax expenditures in stabilizing the economy. Tax expenditures include exemptions, deductions and set offs. Professor Listokin of Yale Law school in the US argues in his paper, Equity, Efficiency and stability; the importance of macroeconomic Perspectives for evaluating income tax policy that many of these deductions especially those for business investment and research have deeply destabilizing effects on the economy and the reason this has not been noticed is because the tax expenditures have never been examined from a macroeconomics perspective. This occurs because investment and research spending are extremely sensitive to the state of the economy.
This extreme sensitivity to the business cycle means that the value of the government subsidy implied by the tax expenditure varies widely from year to year. If incentives for investment change with the business cycle, then tax expenditures like deductions may become stabilizing. For example, if research expenses can be fully deducted in recessionary years but only capitalized in boom years, then firms will have a tax incentive to increase research expenses in recessions. To create such price incentives to invest in recessions rather than in booms, the legislature must be able to time changes in tax treatment or rates with the business cycle. A considerable amount of research, however, casts doubt on the government’s ability to achieve this goal. However, as highlighted earlier, under certain circumstances tax policy can be effectively used for stabilization purposes. In fact, a regime that may not allow these deductions may cause distortions to the investment incentives which can retard investment and growth thus destabilizing the economy.
In Kenya too, the use of deductions and other tax expenditures has recently been a question of debate with some experts recommending that the government assesses the effectiveness of these investment deductions as tax incentives. A report by two Non-governmental organizations (Action Aid and Tax Justice Network) criticized the deductions. According to the report, Kenya is losing more than 1.1 billion US $ a year from tax incentives and exemptions. The Kenya Revenue Authority also confirmed these losses in its report that noted that from 2003 to 2009 it is estimated that $2.5 billion in revenue to incentives. Of these, investment related incentives and export related incentives accounted for 72.4% and 27.6% respectively which translated into 1.7% of the GDP. Perhaps recognizing the effects of the deductions, under the country’s development blue print (the vision 2030) among the fiscal strategies, the country aims at maintaining a strong revenue effort: Revenues are targeted to rise from 20.7% of GDP in 2006/07 to 22% by 2015 and remain at that level to 2030. In this respect, the Government plans ‘to ensure judicious use of incentives… to protect the revenue base.’
Scholars have also noted that the deductions have regressive effects. Because income tax rates are progressive, with marginal rates increasing with income, higher income taxpayers enjoy a larger subsidy. Some advocate the use of uniform refundable tax credits rather than tax expenditures in the form of deductions and exclusions. Uniform refundable tax credits ameliorate the regressive nature of tax expenditures.
Conclusion
In conclusion, despite changing scholarly views on the use of tax policy to achieve a stabilization objective, Kenya’s tax policy is used to achieve a stabilization objective. The capital deductions provided for under the Second schedule to the Income tax Act seek to further a number of objectives including encouraging industrialization, foreign direct investment, scientific research and Agriculture. These objectives in the long run ensure availability of employment; help to create price level stability and a balance of payments which are part of the larger macroeconomic objective of stabilization. However, in the recent past there has been criticism on the effectiveness of the use of these deductions that have been thought to in fact have destabilizing effects on the economy. In light of the foregoing, there is need therefore for the government to assess the effectiveness of these deductions as tax incentives and to consider the viability of replacing them with tax credits or government spending.
The author is a final year law student at Moi University School of law with an interest in financial law.The full paper is available in soft copy and can be availed to readers upon request made to mulenwa@yahoo.com
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