Why bid to tax informal sector might be a challenge

Kennedy Odhiambo straightens a metallic sheet at his workstation at the 'jua kali' section at Kibuye Market in Kisumu on September 24, 2015. PHOTO | TONNY OMONDI | NATION MEDIA GROUP

What you need to know:

  • The government’s problems are spending-related, not revenue shortage.
  • There is need to invest more and spend less money on recurrent expenditure to realise its goals.

The 1996 Nobel Prize in Economics was awarded to two not very well known economists: William Vickrey, a Canadian professor at Columbia University, and James Mirrlees, a Briton who had just left Oxford for Cambridge.

They got the prize for their “fundamental contributions to the economic theory of incentives under asymmetric information”. Not well known does not mean lacking in influential. Anything but.

Vickrey pioneered the economic theory of auctions, and has an auction named after him. A Vickrey auction, a sealed bid auction to buy items such as art, where the highest bidder is awarded the item but pays the second highest bid price.

He also proposed the idea of congestion pricing of infrastructure such as roads. Sadly, Vickrey died three days after the announcement of the award. Three weeks prior, he had presented a pithy essay titled "Fifteen Fatal Fallacies of Financial Fundamentalism", with the subtitle "A disquisition on demand side economics", in which he warned against “the dogmas of the apostles of austerity, most of whom would not share in the sacrifices they recommend for others, failing which we would all be treading on very thin ice”.

The current issue of the IMF Journal Finance and Development leads with an article co-authored by its deputy head of research titled “Neoliberalism Oversold?” and a caption “Instead of delivering growth, some neoliberal policies have increased inequality, in turn jeopardising durable expansion”. The policies in question are financial liberalisation and fiscal austerity— the very ones that Vickrey warned about. But do not hold your breath for apologies from the austerity priesthood.

Mirrlees, (pronounced “Mar-leese”) as he was fondly known at Oxford, is a remarkably self-effacing gentleman whose brilliance was legendary even before the award, but whose lectures were, how shall I put it? A labour of love. Students of development economics and planning would have encountered him by way of a project appraisal methodology known as LMST—the “M” is for Mirrlees.

The nexus of their work is on the subject of optimal tax policy, and specifically on how to balance the economic costs and benefits of progressive (that is, redistributive taxation), which economists refer to as the equity/efficiency trade off. Vickrey formulated the problem in the 1940s, while Mirrlees solved it a 1971 paper. An example will suffice. Consider free education. When school fees is charged, people work extra hard to raise it. If, however, school is made free, some people will work less. Working less is a win win win. They gain more leisure time, pay less tax, and their children still get an education. If the society has a very high leisure preference, everyone would reduce their work effort by exactly the amount of time that it took to earn school fees. National income would contract by as much. Still government would have to collect enough tax to finance the free education. On the benefit side, society would become more equitable as every child would get the same education, and arguably also, with a better educated population it would become wealthier in the future. How to strike this balance is the subject of optimal tax theory.

Which brings us to the kelele emanating from the National Treasury and the Kenya Revenue Authority about widening the tax net. Let’s start with a few facts.

FROM TAXATION

The Kenyan government raises 20 per cent of GDP from taxation. This is a very respectable tax effort, in fact, it is on the upper end of the scale for countries at our level of development.

It is the highest in the East African Community countries by a considerable margin. Where does the government expect this revenue to come from? In a word, well two words, the informal sector—jua kali.

The government’s premise is simple enough. Out of 15 million recorded employment outside of smallholder agriculture, 12.5 million are in jua kali, five informal workers for every person with a payslip.

The definition of informal enterprises are establishments with less than five employees, assuming two to three employees. This translates to anything between four and six million informal businesses. The government has made the assumption that there is a cash cow out there that it is not milking.

Mirrlees, in his Nobel Prize lecture captures succinctly, the challenge for this endeavour: “In the real economy, income actually consists of several elements. It is often easy to distinguish labour income and income from capital, conceptually at least. (In practice, particularly with the self-employed, the distinction might be hard to enforce; and net income from capital, including housing, can itself be hard to measure.)”.

The point he is making here is fundamental. In a formal corporate enterprise, income tax is levied on the company, and from employees. While both are called income tax, the tax base is very different. The corporate tax is a tax on returns to capital, and that on the employees is a tax on labour income. For informal enterprises, this separation is extremely difficult to make. Consider a jua kali carpenter who has a surplus of Sh20,000 in a particular month. How much of this is profit and how much of it is wages?

Given this difficulty, the approach that most governments, including ours, adopt is to levy a “presumptive income tax”, which is charged on turnover. Such a tax known as the turnover tax was introduced a decade ago. It allows businesses with a turnover between Sh500,000 and Sh5 million to pay three per cent of turnover as tax instead of filing the normal company tax returns with their onerous and costly accounting requirements.

The revenue has yet to register on the radar. The figures I have seen, which are up to financial year 2013/14 are an average of Sh200 million per year.

My own sense is that the tax is unlikely to ever amount to much, for two reasons. The first is based on economics 101. One of the first things that students of economics learn is the definition of “perfect competition”. A perfectly competitive market is characterised by free entry and exit, the result of which is that no firm can sustain anything above “normal profit” for long. Normal profits are simply fair compensation of the factors of production and a small reward for risk, which we call “entrepreneurial rent”.

IN PRACTICE

Our jua kali economy is as close to perfect competition as you can possibly get in practice. This is borne out by the very well-known characteristic—a very high rate of business startups, and an equally high mortality rate, which is what we mean by free entry and exit. If it were properly decomposed, we would find that, in fact, the bulk of jua kali income is labour income, not profit. We would also find that the vast majority of the earnings would fall below the tax net.

The second challenge, and potentially more serious one, is the perverse incentives that it portends. Many jua kali services have close non-market substitutes. To illustrate, suppose the government was to enforce the whole bevy: presumptive tax, VAT and catering levy on informal eateries.

This would increase prices by a good 20 per cent. Many people who eat there will find it cheaper to carry packed lunches from home. It would probably also boost the even more informal and business of office deliveries. The move would be counterproductive not only in terms of revenue but also in terms of employment.

What then are the government’s options?

The immediate one is to practise what every dairy farmer knows—first feed the cow, then milk it.

What services does the government provide to jua kali? The preoccupation with taxing it is a case of the government wanting to milk a cow it does not feed.

The jua kali economy, by creating nine out of ten jobs, is already doing more than its fair share for the economy. In addition, it is an incubator for entrepreneurs. The resources spent on taxing it would be better spent nurturing the entrepreneurs to grow into big taxable enterprises.

More fundamentally, the government’s financial problems are expenditure related, not revenue shortage. As I observed, 20 per cent of GDP is a very healthy revenue base. In the 70s, South Korea’s revenue was 15 per cent of GDP, of this, it managed to invest (that is, development spending) four per cent of GDP, meaning that it financed recurrent expenditure on 11 per cent of GDP. Singapore raised 23 per cent and invested 12 per cent which also translates to spending 11 per cent on recurrent, while Malaysia raised 21 per cent and spent only 9 per cent on recurrent thereby investing 12 per cent.

By contrast, the Philippines, which was then richer than the tigers, raised 14 per cent of GDP just about the same as Korea but spent 16 per cent on recurrent, meaning it borrowed an additional two per cent of GDP for recurrent expenditure.

When we hear of high national savings rate of the Asian tigers, most of us think only of households and the private sector, while in fact, it is public thrift that set them apart from other developing countries.