Uhuru Budget: What About the Deficit?

While it would be overly dramatic to describe the state of Kenya’s finances as being in the red zone it is safe to say that there are some slight causes for concern. These causes for concern mainly relate to the growing levels of debt and the deficit. As things stand the total debt is currently around 50 % of GDP while the past budget deficits have hovered between 5.5% – 6.8 % of GDP.

A budget deficit is not inherently devastating, seeing as governments are not in the business of profit making. In fact, it would be reckless for a government to sit on a huge surplus while that country faces welfare, recurrent and development expenditure needs. However, large deficits year after year translate into troublesome/unacceptable government debt, which is more often than not paid for by future generations by way of taxes. This is the case in Kenya, where over the last few years, government spending has consistently exceeded government revenues. And based on the recently released estimates from the Treasury, showing planned spending of KShs. 1.2 trillion, all indications are that government spending is on a one way path upwards. This, coupled with the government reducing tax on various fuel products and cereals, all have the effect of further widening the deficit, accumulating the debt and further burdening future generations.

Yet another deficit would invariably mean that the Treasury will resort to more borrowing. As the CBK’s recent increased activity in the Treasury bill and bond market shows, when the government is desperate for cash interest rates in the borrowing markets go up. This in turn increases the costs of servicing the debt. Just this May, the average interest rate that the Treasury had to pay on three month treasury bills was 4.7%, while in mid-January the interest rates on the three month bills was only 2.4%.
Considering that the government spent approximately KShs.3.5 billion purely on paying interest on the public debt from June 2010 to December 2010, at a time when the interest rates were below 2.4%, these latest interest rate increments mean that we might be coughing up way over KShs.4 billion to service the debt by September. These increments also have a knock-on effect on all lending markets- key amongst them commercial bank interest rates. This is bad news for the entire private sector, from construction to agriculture to finance. Seeing as these are currently the pillars of the economy, high interest rates will undoubtedly have a negative effect on our GDP growth. Despite the fact that we are far from a sovereign debt crisis à la Greece and Portugal, it is clear that perpetual government deficits are not in our best interests.

So, how to get rid of the red ink?

The textbook response would be to either increase government revenue or cut spending. The cut spending option on a large scale is currently not on the table, given the fact that we need to invest billions more in infrastructure like roads, railway, agriculture, ICT and several others. Boosting tax revenues remains the best option. While the Kenya Revenue Authority (KRA) has done a commendable job in terms of annually collecting relatively more income, they have regularly failed to meet the revenue targets set for them. Raising VAT and income tax rates may seem viable options on the surface, but various studies have shown that in most cases increased tax rates have the effect of pushing some individuals and companies into the black market and worse yet out of the tax net.

The better option would be to reintroduce Capital Gains Tax (CGT). This tax, which targets profits made from the sale of assets, will have the immediate effect of increasing tax revenues while at the same time not burdening the economy’s lower income earners. It was suspended by parliament in 2002, but now is the time for parliament to take a fresh look at this promising fiscal tool.

CGT would hit a number of transactions that would immensely boost the government coffers. One such industry is the stock market. Statistics show that from January to March 2011, the total equity turnover in the NSE was $ 275.8 million. There is no doubt that given this figure, the total capital gains made over a 12 month period are quite substantial (albeit likely to be below the turnover figure). Profits made by individuals and entities that do not list stock trading as one of their objects would attract CGT if it were introduced in the budget.

Other markets potentially feeding the CGT include real estate. Notably so, the property market outperforms the NSE in terms of returns. Using 2000 as a base year, the returns from the property market have been three times the returns of the stock market. Whereas a proportion of these gains are in the form of rental income, which would fall under income rather than capital gains, profits from the sale of property by non-property companies would also attract CGT.

Perhaps one of the strongest arguments in favour of CGT is that its main downside is simply the labour intensity of its policy development, and not that it has questionable effectiveness or high costs to sensitive populations. That is, if the Finance Ministry deems it fit to reintroduce CGT they must ensure that the relevant provisions or regulations in the Income Tax Act relating to CGT are realistic and workable. Achieving this is far from impossible. Studying CGT rules of countries that currently enforce the tax so as to modify our old CGT rules would be advisable. Calculation and payment of the taxes should be relatively simple to encourage compliance. To enhance it as a tax that enables vertical redistribution, the Ministry should also ensure that the tax applies to only higher value transactions. The law should also be clear on which gains are considered as income and which are considered capital since many tax avoidance openings may arise given that the two rates (income tax vs CGT) are usually different.
All in all CGT will definitely boost the coffers of the exchequer thus reducing the deficit. It could be argued that introducing CGT would have the effect of putting off investors but Treasury can guard against this by ensuring that the CGT rates are not excessively high.

It is highly unlikely that reintroducing CGT will make us less competitive in relation to our African neighbours since countries like Uganda, Tanzania, South Africa, Botswana, Senegal, Nigeria and Ghana all apply CGT. It is also a tax that is unlikely to be alien to overseas investors since countries like Japan, Italy, Canada, Brazil, United Kingdom, United States, Poland, China, Australia, France, Sweden and Denmark are also amongst some of the many countries that charge CGT.

It is thus my sincere hope that Treasury considers reintroducing CGT to aid in plugging our growing deficit problem.

3 thoughts on “Uhuru Budget: What About the Deficit?

  1. Great ideas…. We’ve got a big budget. we need to cast our net wider in revenue collections. Government borrowing erodes private investment by increasing cost of capital. Treasury still has many unexploited options.

  2. Pingback: #iDontBelieve: “The Power of The People vs. The People in Power” | Diasporadical

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