The hue and cry on the increased taxes on petroleum products has reverberated across class, tribe, and political divide. The tax increase has raised the cost of fuel by Sh17 per litre. This was to help in reducing the budget deficit as agreed between the government of Kenya and the International Monetary Fund two years ago.
A budget deficit occurs when government spending is greater than tax revenues. This leads to accumulation of public sector debt. To correct a budget deficit, a country can cut government spending, raise taxes, or promote economic growth. When the deficit is unsustainable, it leads to higher interest payments and in a worst case scenario, a loss of confidence in the government by the global money market.
Budget deficits can be caused by certain unanticipated events such as the repeat election we had last year, expanding welfare programmes, tax evasions, demographic pressures of an aging or a fast-growing population or corruption. It is forecasted that the increased tax will earn the government an additional Sh71 billion annually. However, this is akin to chasing a unicorn, because increasing tax to raise additional revenue is a self-defeating strategy. Allow me to explain.
One, it stokes avoidance. Many people devise means of circumventing to pay higher taxes. Already, there have been reports of Kenyan motorists buying fuel in the neighbouring countries, where it is retailing at roughly Sh22 cheaper than in Kenya. A boycott from petroleum suppliers has also caused a widespread fuel shortage. This results in lower or zero sales. In other scenarios, when a government raises taxes, some of its wealthy citizens take up new citizenship in tax havens, and enterprise owners relocate their industries to other countries with more favourable tax regimes. An example is the proliferation of sweat shops in Asia. Inadvertently, the net effect of avoidance is reduced tax revenue collection.
Two, it slows economic growth. This is because it is impossible to ring-fence the costs of any tax. For instance, in the case of public transportation, an increase of tax on petrol or diesel shifts the economic burden to the travelers. Humans are praxeological beings. They rank their needs according to their available means. For example, if you had only one litre of water and had to choose between cooking, brushing your teeth or watering your garden, you would use it on the need you rank highest, which, in this case, is cooking. The same principle applies when Kenyans are compelled to pay higher prices for transportation. They may opt to walk to work, which leads to fewer clients for matatus, leading to fewer trips thus fewer litres of fuel purchased. This leads to lower revenues generated by the fuel entrepreneur and matatu owner, causing them to downsize. And with job losses, people stop purchasing other goods and services. A replication of this cycle in other sectors eventually results in a sluggish economy and ultimately lower tax revenues.
In economics, the Laffer Curve theory explains this relationship between tax rates and the tax revenue. It illustrates that the more an activity is taxed, the less of it is generated. The converse also holds true. This means that lower taxes boost economic growth and underpins what is called the supply-side economics.
Let us conceptualise this on a graph and plot the revenue along the x-axis, the tax rate along the y-axis, and the point at which they intersect is zero. If the tax rate is zero per cent, no tax revenue is generated because nobody is paying taxes. Likewise, if the tax rate is 100 per cent, the tax revenue is still zero because nobody is willing to work and have all their income taxed by the government leaving them with nothing. When taxes increases from zero, it boosts government revenue immediately. And the more the taxes go higher along the y-axis, the more the revenue that is collected along the x-axis. However, as the tax increase continues, the payoff in additional revenue begins diminishing as the tax base reduces causing the curve to boomerang backwards to zero.
The Laffer curve theory has two effects: One is arithmetic and the other is economic. Proponents of demand-side economics only focus on the arithmetic because they view this effect as static. It means that when tax rates are lowered, the tax revenue will also be lowered by the amount of the decrease in the rate, and vice versa for increasing the tax rate. So, hypothetically if the tax rate is one per cent, the revenue may be Sh10,000, and two per cent would generate Sh20,000. This decreases the after-tax income with every tax increment. Similarly, if the tax rate is 0.5b per cent, the revenue generated would decrease to Shs5,000.
Demand-side economists, however, ignore the economic effect that recognises the positive impact that lower tax rates have on work, output and employment. When people are taxed less, it incentivizes them to work, spend save and invest more. This increases their income and spending on other goods and services, thus stimulating economic growth. Entrepreneurs who are taxed less are able to re-invest into expansion of their enterprises or invest in new enterprises thus hiring more workers, and producing more goods and services. The net effect is a boost to economic growth, which in turn generates a larger tax base and eventually a higher tax revenue for the government. Conversely, raising taxes has the opposite effect.
Tax rates follow the universal principle of demand and supply. The more costly a product or service is, the less of it that will be demanded by the consumers and produced by suppliers.
I, therefore, submit that the government should dare to do different. They should lower taxes across the board. Then sit back and watch as the economy organically flourishes. As elucidated earlier, the government is already losing and likely to lose more, if they do not expeditiously pivot.
Therefore, my unsolicited advice to government is that you cannot make a fat man skinny by tightening his belt: He has to shed the weight. Likewise, shed off government excesses of waste and spending, and embrace austerity.
I contend that for a nation to try to tax itself into prosperity is like a man standing in a bucket and trying to lift himself up by the handle - Winston S Churchill