KENYA METHODIST UNIVERSITY

NAME

LETEIPA ERICK SOPIA

REG NO

BUS-1-6444-1/2015

COURSE

PUBLIC FINANCE

COURSE CODE

ECON 346

TASK

ASSIGNMENT

LECTURER

DATE

KIBET KIRUI

01/10/2015

1. Critically evaluate the public debt management policy in Kenya stating the
strength and weaknesses of such a policy
Debt management policies are written guidelines, allowances, and restrictions that guide
the debt issuance practices of state or local governments, including the issuance process,
management of a debt portfolio, and adherence to various laws and regulations. A debt
management policy should improve the quality of decisions, articulate policy goals,
provide guidelines for the structure of debt issuance, and demonstrate a commitment to
long-term capital and financial planning. Adherence to a debt management policy signals
to rating agencies and the capital markets that a government is well managed and
therefore is likely to meet its debt obligations in a timely manner. Debt management
policies should be written with attention to the issuers specific needs and available
financing options and are typically implemented through more specific operating
procedures.

2. State and explain the key tax reforms in Kenya

Tax reform is the process of changing the way taxes are collected or managed by the
government. It may involve the adoption of a Value Added Tax (VAT), the expansion of
the VAT, the elimination of stamp and other minor duties, the simplification and
broadening of personal or corporate income or asset taxes, or the revision of the tax code
to enact comprehensive administration and criminal penalties for evasion.
Excise Taxes
Excise taxes have been an important component of total tax revenue in Kenya. In theory,
excise taxes have several advantages over other types of taxes, such as administrative
ease of collection. These taxes also tend to be levied on specific types of commodities,
for different reasons. They are applied in Kenya to compel the users of excised
commodities to internalize the externalities that excisable commodities such as tobacco,
alcohol and petroleum products tend to have. Excise taxes may also be used merely to
generate revenue.
Customs duties:
Towards export-led industrialization .The contribution from customs duties to the
countrys total revenue is mainly driven by the trade policy Kenya has pursued since
1984 to 2015. There have been changes in the number of tariffs and in the rates ever since
the country started implementing structural adjustment policies. The objectives
underpinning tariff changes have been attempts towards greater openness, but there have
also been episodes of protectionism for specific sectors or subsectors of the economy.
These are summarized below. We also examine how this has influenced tariff rates, their
structure and ultimately the contribution of customs duty to total tax revenue. It is clear,

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however, that unlike many developing countries, Kenya has not relied to any great
extent on import duties.
Corporate Income Tax
Most of the firms in Kenya are currently registered as Corporate Income Tax payers. Tax
rates on domestic firms have fallen from 45 percent in the mid-1970s to 30 percent
currently. (Tax rates 19 imposed on foreign owned corporations were 52 percent, but have
fallen over the last thirty years to 32.5 percent now.) Corporations that locate in Export
Processing Zones, which are found in Nairobi and Mombasa, and can show that they
produce for export, are granted a generous ten-year corporate tax holiday. Firms outside
the EPZs can deduct twenty percent of the costs of investment in (new or second hand)
plant and equipment up front (equivalent to a 6 percent investment tax credit) and then
amortize the remaining cost of the investment following specified depreciation formulae.
Certain investments are given favorable treatment, such as hotel construction and some
agricultural investment.
Personal Income Tax
Income tax is the normal tax which is paid on your taxable income.
Examples of amounts an individual may receive, and from which the taxable income is
determined, include

Remuneration (income from employment), such as, salaries, wages, bonuses,

overtime pay, taxable (fringe) benefits, allowances and certain lump sum benefits

Profits or losses from a business or trade

Income or profits arising from an individual being a beneficiary of a trust

Directors fees

Investment income, such as interest and foreign dividends

Rental income or losses

Income from royalties

Annuities

Pension income

Certain capital gains

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VAT
In 1989, the government passed legislation to introduce a credit-invoice value-added tax,
which became effective on January 1, 1990. At this time the concept of tax policy
simplicity had not firmly taken root in Kenya: the VAT was introduced with a standard
rate of 17 percent, but with 14 other rates (the highest being 210 percent) that made the
VAT appear more like a differentiated commodity tax regime. This multiplicity of rates
was particularly difficult to rationalize in light of the fact that excise taxes on specific
classes of goods were maintained during (and indeed after) the transition and
implementation of the VAT.
The high and wide range of rates is thought to have led to widespread misclassification
and other methods of tax evasion. In response to these concerns, the number of VAT rates
was quickly reduced to four by 1993-94, when the top rate was set at 40 percent. Since
then, the rates have been further lowered, and currently there is just a single standard rate
of 16 percent, with some sales zero-rated and others exempt

Economic restructuring
The country adopted a trade policy in 1984/2015 that clearly refrained from
protectionism as its overriding objective. There were distinct efforts at introducing
restructuring incentives and reducing the cost of production. During this period, most
duties exceeding 25 per cent were cut for the express purpose of restructuring the
economy towards export production, and away from the highly protected and inefficient
pattern of industrialization that had been based on import substitution. Zero rating for
agricultural inputs was also introduced during this period to improve production. Import
tariffs on raw materials, intermediate inputs for industry and capital goods were
decreased in the efforts to restructure.
Enhancing efficiency
The economy had suffered significantly from an inefficient production system that had
resulted from the countrys protectionist trade policy. During trade liberalization, tariff
rates were reduced in favour of intermediate and capital goods in order to trim prevailing

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economic distortions and to encourage local production. Duties on agricultural inputs
continued to be removed in hopes that the country could boost agricultural productivity.
Simplifying and rationalizing the tariffs
As Kenya continued to pursue a trade policy geared to boosting industrialization and
expanding domestic manufacturing, it was realized that the tariff structure was too
complex. Subsequently, trade policy focused on tariff rationalization with the aim of
achieving a four-rate system (including duty free) that would simplify import duty
administration. In 1988/9, the country reduced the number of tariff categories from 25 to
17. Another five tariff categories were abolished the following year, bringing the total
number of tariff bands to 12. This last rationalization lowered import duty rates on raw
materials and intermediate goods by an average of 5 per cent. At the same time, however,
duties on some of the refined and finished goods were increased; clearly indicating that
trade policy had not been completely forgotten as an instrument of protectionism.
Export competitiveness
As the country continued to restructure the economy, there were deliberate efforts to
address the issue of export competitiveness by lowering production costs through smaller
average tariffs and by narrowing their dispersion. In 1990/1, the top duty rate of 135 per
cent was cut to 100 per cent. Duties on imported raw materials, intermediate goods and
spare parts were reduced further to improve the competitiveness of local goods in export
markets. Further adjustments were undertaken: over the three-year period 1991/2 to
1994/5 the number of tariff bands was successfully reduced from 15 to 11 with a ceiling
rate of 70 per cent, to nine tariff bands with a 60 per cent maximum rate, and finally in
1993/4 to only seven bands, underscoring the governments commitment to the policy of
import liberalization as part of the structural adjustment programme that advocated trade
liberalization in order to make exports more rewarding
Agricultural sector protection
While there was a clear policy of zero-rated inputs for the agricultural sector, by 1995/6
there was again a deliberate move towards protectionism with either a specific or ad
valorem import duty for agricultural products. In 1996/7, several ad valorem rates were

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proposed on major products. Falling world prices were cited as justification for the
need to introduce the suspended 70 per cent duty on agricultural imports to protect the
Kenyan producers faced with continual stiff competition.
The re-entry of industrial protection
The trade liberalization policy that had been aggressively pursued since the mid-1980s
started facing serious issues of credibility in some of the sectors of the economy. It was
argued that there had been blind liberalization, which hurt some of the domestic
producers of import-competing goods, and by 1999/2000 a policy shift towards the
protection of some sectors started to creep in. In addition to increasing rates on
agricultural commodity imports, the suspended duty on commercial vehicles and textiles
was reversed to strengthen domestic businesses. This clearly resembled the
industrialization policy of import substitution that had been discredited earlier for
encouraging inefficiency in the industrial sector.

3. List and explain five cannons of taxation highlighting the conflicts and
interdependence
Adam Smith cannons of taxation
Equity: The subjects of every state ought to contribute towards the support of the
government, as nearly as possible, in proportion to their respective abilities; that is, in
proportion to the revenue which they respectively enjoy under the protection of the state.
Certainty: The tax which each individual is bound to pay ought to be certain, and not
arbitrary. The time of payment, the manner of payment, the quantity to be paid, ought all
to be clear and plain to the contributor, and to every other person.
Convenience: Every tax ought to be levied at the time, or in the manner in which it is
most likely to be convenient for the contributor to pay it.
Economy: Every tax ought to be so contrived as both to take out and to keep out of the
pockets of the people as little as possible, over and above what it brings into the public
treasure of the state.

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Other Canons of Taxation:
Economic science has progressed much since the days of Adam Smith. Later writers have
added to his canons.
The additions are:
Canon of Productivity:
This canon emphasizes that a tax should bring in a substantial amount of money to the
State. After all, the main object of the taxing authority is to secure funds. Therefore, a tax
which does not yield a fair income is not of much use. It is much better to have a few
taxes which yield good revenue instead of many taxes yielding a little.
Canon of Elasticity:
This canon points out that a tax should automatically bring in more revenue as the
countrys population or income increases. There should be an automatic link between the
needs of the State and resources of the people. If, in an emergency, an increase in the rate
of the tax brings in increased income, the tax is elastic.
Canon of Simplicity:
It argues that the tax system should be simple; otherwise there would be confusion and,
worse still, corruption. During the war and after, certain taxes, e.g., on sale of cloth and
lather essential supplies in India resulted in corruption mainly because they lacked in
simplicity.
Canon of Variety:
It is also necessary that the tax system off a country should be diversified. Reliance on
just a few taxes is risky. The revenue will not be sufficient, nor will it be fair, because it
will not touch a large number of people. In order to be just, a tax system must be broadbased. In order to be adequate, it must be diversified, having a wide coverage over
commodities and persons.

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Canon of Flexibility:
Flexibility in taxes is different from elasticity mentioned earlier as a canon. Flexibility
connotes the absence of rigidity in the tax system. A flexible tax quickly adjusts to the
new conditions; on the other hand, elasticity means that income can be increased.
Presence of flexibility is a pre-condition for elasticity. Lack of flexibility in a tax can
cause financial troubles to a State.

5. Using relevant data from 2014/15 budget statement, explain how the government
intends to fill in the budget deficit.
1. Refunding:
Refunding of debt implies the issue of new bonds and securities by the government in
order to repay the matured loans.
In the refunding process, usually short-term securities are replaced by issuing long-term
securities. Under this method the money burden of public debt is not relinquished but it is
accumulated owing to the postponement of debt redemption.
2. Conversion:
Conversion of public debt implies changing the existing loans, before maturity, into new
loans at an advantage in servicing charges. In fact, the process of conversion consists
generally, in converting or altering a public debt from a higher to a lower rate of interest.
A government might have borrowed at a time when the rate of interest was high. Now,
when the rate of interest falls, it may convert the old loans into new ones at a lower rate,
in order to minimise the burden. Thus, the obvious advantage of such conversion is that it
reduces the burden of interest on the taxpayers. Furthermore, lower interest rates on
public loans would mean a less unequal distribution of income.

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The success of conversion, however, depends upon:
(a) The creditworthiness of the government,
(b) The maintenance of adequate stock of securities,
(c) The efficiency in managing the public debt.
Furthermore, for a successful conversion, the government will have to offer new lowinterest bearing bonds at a discount rate and which will have to be redeemed at full value,
causing thereby a capital appreciation (which may be even free of income-tax).
Ultimately, thus, the conversion does not benefit the treasury as the price of the bonds
will have to be paid at a higher rate (i.e., at par, at the time of redemption) than its selling
price, which in turn increases the liability of the government in future, for a capital sum
greater than that borrowed will have to be repaid. Hence, conversion is no substitute for
repayment, when a substantial reduction of burden of public debt is desired.
Dalton, as such, opines that debt conversion does not really relax the debt burden.
Because, a reduction in interest rate reduces the ability of bond-holders to pay taxes
which may cause a reduction in public revenue, thereby reducing the governments
capacity to redeem loans.
3. Surplus budgets:
Quite often, surplus budgets (i.e., by spending less than the public revenue obtained) may
be utilised for clearing off public debts. But in recent years due to ever-increasing public
expenditures, surplus budget is a rare phenomenon.
Moreover, heavy taxes have to be imposed for realising a surplus budget, which may
have dire consequences. Or, when public expenditure is reduced for creating a surplus
budget, a deflationary bias may develop in the economy.
4. Sinking fund:

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A sinking fund is a fund created by the

government and gradually accumulated

every year by setting aside a part of current public revenue in such a way that it would be
sufficient to pay off the funded debt at the time of maturity. Perhaps, this is the most
systematic and best method of redemption.
Sinking fund is in essence, like a depreciation fund prudentially created. Under this
method, the aggregate burden of public debt is least felt, as the burden of taxing the
people to repay the debt is spread evenly over the period of the accumulation of the fund.
The practice of a sinking fund inspires confidence among the lenders and the
governments creditworthiness increases thereby.
5. Terminable annuities:
This method of debt redemption is similar to that of the sinking fund. Under this method,
the fiscal authorities clear off a part of the public debt every year by issuing terminable
annuities to the bond-holders which mature annually. Thus, it is the method of redeeming
debts in installments. By this method, the burden of debt goes on diminishing annually
and by the time of maturity it is fully paid off.
6. Additional Taxation:
The simplest measure of debt redemption is to impose new taxes and get the required
revenue to repay the loan principal as well as the interest.
This method causes redistribution of income by transferring the resources from taxpayers to the hands of bond-holders. It may also impose a burden on the future generation
if new taxes are levied to repay the long-term debts.
7. Capital Levy:
Capital levy is strongly recommended by Dalton as a method of debt redemption with the
least real burden on the society. Capital levy refers to a very heavy tax on property and
wealth. It is once- for-all tax on the capital assets and estates.
8. Surplus Balance of Payments:

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The redemption of external debt, however, is possible only through an accumulation of
foreign exchange reserves. This necessitates creation of a favourable balance of payments
by the debtor country by augmenting its exports and curbing its imports, thereby
improving the position of its trade balance.
Thus, the debtor country has to concentrate on the expansion of its export sector
industries. Further, loans raised must be productively utilised, so that they may become
self-liquidating, posing no real burden on the economy.
In underdeveloped countries like India, where external debt has increased tremendously,
it is necessary that its burden is reduced by changing the terms of repayment or by
rescheduling the debts.
In fact, the best redemption policy is a that part of the public debt, internal as well as
external is redeemed every year so that there is no mounting of a total real burden of debt
upon the present generation or on posterity.

6. Explain the likely consequences of an increased public wage bill for a developing
nation like Kenya
7. Enumerate the reasons why some public goods cannot be left to the private sector
alone
8. Discuss the challenges of privatization of public services or entities in Kenya