Introduction

KRA’s proposed removal of the KES 5 million value-added tax (VAT) registration threshold. This would require all businesses to regardless of turnover to remit VAT at the standard rate (16%). The policy direction is clear: to expand the tax base, increase VAT’s contribution to gross domestic product (GDP), share tax responsibility more equitably across the entire commercial sector, and bring MSMEs into the formal economy.

At its core the proposal raises a more fundamental question: will the policy achieve its intended outcome and at what cost? Public policy is considered effective if when implemented it achieves its intended impact. Public policy is considered efficient if it is the least costly way of achieving the intended impact. History suggests when these two aren’t aligned the results can be counterproductive.

Policy Objective & Intended Outcome

The objective of expanding VAT to MSMEs is straightforward. In theory the intended outcome of expanding VAT will be:

• Increase tax revenue by widening the base.
• Improve equity across tax payers.
• Accelerate the formalization of the informal sector.

However, achieving this outcome depends just not on legislation but on how businesses respond to the incentives created.

The Enforcement Challenge

From an enforcement perspective micro-enterprises have historically been one of the hardest sectors to tax. There are structural characteristics of micro-enterprises that make them difficult to tax, these include:

1. Low Visibility- For the authorities these businesses are hard to detect income and harder to enforce compliance. This sector presents a challenge due to the prevalence of cash-based transactions, lack of formal records and reliable turnover data and minimal banking footprint.
2. High Elasticity to Regulation- These businesses can easily change behaviour. Some micro-enterprises respond to regulations by splitting businesses into smaller units, increase cash transactions and move further into the informal trade.
3. Limited Compliance Capacity- These businesses being informal tend to lack the systems and skills that larger businesses have. Examples of this are limited bookkeeping skills, no accounting systems, poor understanding of VAT systems.
4. Cost of Enforcement vs Revenue Yield- For the authorities these businesses represent a high opportunity cost to audit, opposed to a large taxpayer who is easier to audit and penalize as illustrated below:

• Auditing 1 large taxpayer → high yield
• Auditing 1,000 micro traders → low yield, high cost

Lessons from History: When Tax Policy Backfires

History provides numerous examples of how well-intentioned tax policies can produce unintended outcomes when incentives are misaligned.

In each case taxpayers did not comply with the intent of the law but rather adapted their behavior to minimize tax exposure. The risk is that VAT expansion may produce a similar outcome of reduced visibility rather than increased compliance.

Applying These Lessons to VAT Expansion

The proposed VAT expansion is likely to generate resistance from the MSME sector which is the main target. This is due to:

1. Economic pressure- VAT introduces a 16% cost increase. For a business operating on thin margins the choice is to either increase prices (affecting demand) or reduce profitability e.g. A small trader operating at 10% margin cannot absorb 16% VAT without increasing prices or reducing profitability.
2. Competitive distortion- The proposed VAT expansion creates unfair competition between formal businesses which charge VAT (higher prices) and informal businesses which avoid VAT (lower prices).
3. Perceived increased cost of compliance- MSMEs are likely to view VAT as a net cost rather than a pass-through cost given limited input VAT recovery due to reliance on informal suppliers. This is compounded by the administrative burden of invoicing, record keeping and monthly filings. Digital tax systems like eTIMS incentivize formalization by allowing businesses to claim expenses while VAT increases cost of visibility. This creates policy tension where formalization is both incentivized and penalized at the same time.

Example:

In a business district like Eastleigh characterized by informal high-volume trade which is highly cash driven and built on speed, trust networks and low documentation. This proposal is likely to have low uptake because it risks turning formalization into a cost rather than a benefit and businesses will respond by reducing visibility. In such an environment VAT compliance is not just difficult but structurally incompatible with how business is conducted.

Effectiveness vs Efficiency Test

• Effectiveness (Will the policy achieve its intended outcome?)- While the objective is to broaden the tax base and increase VAT revenue. MSMEs are likely to respond by under-declaration, informality and reduced visibility. As a result, the policy risks falling short of meaningfully expanding the tax base.
• Efficiency (Is this the least costly way to achieve the outcome?)- The administrative burden on small businesses combined with the high cost of enforcement relative to revenue yield raises concerns on efficiency. Significant resources will be required to enforce compliance in a segment that is structurally hard to tax with limited corresponding returns.

Policy Design Considerations

1. Phased implementation- A phased approach through sector-based rollout would allow MSMEs to adjust operationally while allowing KRA to refine its approach while building enforcement capacity. For example, in Eastleigh targeting semi-formal players first such as importers and wholesalers provides a viable entry point.
2. Alignment with eTIMS- The success of VAT expansion depends on effective integration with systems such as eTIMS. This requires simplifying usage, reducing friction and ensuring supply chains are sufficiently compliant allowing meaningful input VAT recovery.
3. Incentives for formalisation- Formalisation cannot be driven by enforcement alone it must be economically rational. Many businesses in Eastleigh have access to informal credit so traditional incentives (access to credit, tenders) have limited pull. However, linking compliance to import facilitation, customs clearance efficiency would make them commercially relevant to traders’ actual operations.
4. Taxpayer education- This is a critical but overlooked constraint taxpayer education is therefore not a supporting activity but it is a core component of policy effectiveness. This requires a shift from awareness to practical guidance. For example, having industry specific, step-by-step scenario-based guidance such as “How to file VAT as a small trader?”.

Conclusion

The proposed VAT expansion reflects a clear fiscal objective but its success hinges on the prevailing economic conditions and taxpayer behavior. The current environment is characterized by rising fuel costs, inflationary pressure and heightened customer price sensitivity. MSMEs face shrinking margins and limited ability to pass on additional costs. As a result, VAT is no longer perceived as a neutral tax but as a direct strain on already constrained cashflows.

The result is the likelihood of resistance increases as businesses are likely to delay compliance, under-declare and revert to informal channels. In such conditions survival takes precedence over regulatory alignment. When the cost of compliance exceeds the benefit of visibility policies designed to expand the tax base instead push it further into informality.

This is not an argument against taxation or compliance, but a recognition that policy outcomes are ultimately determined by the incentives they create.

Content By:

Phil Njoka

Associate

phil.njoka@ke.andersen.com