The government is focusing on balancing policy plans and fiscal targets

In mid-2014 Kenya’s fiscal position was a mixture of positives and negatives, with the country benefitting from a position of comparative stability while facing up to a selection of potential future risks. The government’s task currently is to maintain fiscal discipline across both national and local balance sheets, while at the same time embarking on development initiatives that bring short-term spending commitments but promise long-term gains.

The country’s primary fiscal challenges here are in part familiar and common to emerging markets throughout the region, such as Kenya’s low tax base and the large proportion of its economy that is unregistered and untaxed. Revenue from tax missed targets in the 2012/13 budget cycle, and came in at 10.2% of GDP against an expected 12.4%. (Kenya’s fiscal year begins on July 1 and ends on June 30.) Current spending on public sector wages is also an issue – as it is in so many African markets – and in the same budget period it amounted to 7.8% of GDP, which the state is aiming to keep at 7% or less. There is often a gap between policy and execution that was the practical effect of reducing government spending from what is planned, crimping economic growth.

Major Changes Ahead

However, a number of the more immediate hurdles are transitory and should bring long-term benefits. Changes mandated in the 2010 constitution, starting with the devolution of areas of state power to 47 newly created counties, are costly for now but expected to create a foundation for stronger growth in the future.

The transition period is expected to last several years, with elevated associated costs throughout the duration, although the state will also need to maintain capital expenditures on key development and infrastructure projects alongside devolution. As a result, the government’s fiscal policy aims to strike a balance between an expansionary approach and a disciplined one. “Kenya has big dreams and not enough money,” said Aly-Khan Satchu, the CEO of the Nairobi-based investment and advisory firm Rich Securities. “There needs to be a considered strategy for the order in which they are going to do things.”

The challenge of balancing policy plans and fiscal targets is not unique to Kenya, and in 2014 some of the continent’s other fast-growing markets were struggling in this area. Both Ghana and Zambia saw their credit ratings downgraded by Fitch Ratings recently for the same reasons. Ghana’s 2013 was marked by cost overruns on wages and interest payments, and in Zambia spending on subsidies pushed the budget deficit from a planned 4.5% to 8.5%.

Shifting Focus

The tension between the competing goals of fiscal discipline and broad-based development was highlighted by the World Bank, which in 2013 praised Kenya for its administrative abilities, but attributed muted growth to some shortcomings in the same category. In its June 2013 economic update, the bank concluded that discipline in fiscal policy was paying off, with noted accomplishments including adhering to spending targets throughout the election campaign and vote of 2013, and coping with the rising costs of protecting the country from security threats. Kenya has faced repeated attacks from Al Shabab, based in neighbouring Somalia, and that threat is an ongoing one.

But six months after that June report the World Bank cut its growth forecast for Kenya for 2013 and 2014. One reason cited in the analysis was the government’s struggle to spend all of what it had budgeted, a situation that was in part a consequence of the election cycle. The World Bank also blamed the devolution process, which has resulted in disagreements over accountability and power-sharing between counties and the national legislature, and a hiring freeze at the county level until a public sector audit is completed to determine the required employment levels in counties. Concerns over corruption and opacity in licensing and procurement have also slowed down progress at the local level.

The government believes that the costs and challenges associated with the devolution process are a short-term fiscal concern that will dissipate over time as direct and indirect benefits accrue. Decentralising the economy is expected to boost economic growth, as well as spread it more evenly across the country, with the counties – each of which is given a mandate to pursue its own economic development strategy – taking a more aggressive approach to soliciting investment and trade.

Revenue

Revenue raised in the 2013/14 fiscal year totalled KSh1.18trn ($13.45bn), or 25.3% of GDP. The state is trying several measures to capture more revenue from existing output. A law containing a series of adjustments to how value-added tax (VAT) is collected was passed in 2013 that added further clarity and efficiency to the process, lowering the cost of collection for the government as well as boosting the overall total. The royalty rate for mined output has been hiked, and new sources are also on the cards. Capital gains taxes have not been levied since 1985 but are set to return once the 2014 Finance Bill is signed into law.

While there have been no specific details shared, the expectation is that a capital gains levy will be applied to the real estate sector first, and perhaps later on in other areas such as securities (see analysis). The Kenya Revenue Authority has been increasing its enforcement efforts since the new VAT law came into effect in September 2013, with a greater frequency of audits on large-scale taxpayers. An additional 2% of GDP was collected this way in the first quarter of fiscal 2013/14, according to the IMF.

Kenya also wants to boost revenue by moving informal sector activity into the formal, taxable economy, which is often an opportunity-specific undertaking and also can be a by-product of other reforms. One example is a move to make riding buses a cashless transaction. The chosen method of transport for most Kenyans is the matatu, the local name for a minibus. Pilot projects under way now allow fares to be collected using near-field communications technology (NFC): riders can add value to prepaid fare cards at bus stops or through bank agents, and swipe them against a bus driver’s NFC-enabled smartphone to complete the transaction.

This method creates a transaction record, enabling administrators to calculate the value of money flowing through the system. That would be the first step to bringing a major informal-economy employer into the taxpaying realm. An estimated 300,000 Kenyans work as drivers, fare collector, bus stop attendants or in other roles in matatu operations.

Debt Levels

The country faces significant debt and $600m of the $2bn raised from a eurobond issue in June 2014 has been earmarked to repay existing debt, while the rest will be used to fund infrastructure projects. The country’s debt-to-GDP ratio increased from 42.9% to 53.5% between 2008 and 2009, with the debt load reaching KSh2.11trn ($24bn), or 57% of GDP, by the end of December 2013. This prompted the IMF and the World Bank to raise a red flag over the rising debt levels, although the debt was seen as likely to decline later in 2014.

In its July 2014 outlook ratings agency Fitch affirmed its “B+” stable rating, citing Kenya’s five-year growth rate and investment in infrastructure and agriculture, among other factors. Fitch said, “Rising government revenue, well developed domestic capital markets and strong institutional capacity increases Kenya’s debt carrying capacity relative to its peers. The upward revision to GDP expected in September would see debt decline to 45% of GDP, only slightly above the ‘B’ median of 42.5%.”

Spending

On the other side of the fiscal equation, the hope is that with the 2013 election past the government can hold closer to its spending projections. Spending for the 2014/15 budget cycle is projected at KSh1.52trn ($17.3bn), or 32.9% of GDP. According to data from the National Treasury, Kenya’s version of a ministry of finance, spending in nine of 10 surveyed areas lagged the committed amount as of the end of 2013, with national security being the only exception. Spending on energy, infrastructure and ICT was 63% of what was planned, and the rate was 69% for environmental protection, water and housing. At the high end of the range, at 89% and 87% of their targets, respectively, were governance, justice, and law and order, and education.

To manage payrolls Kenya instituted a hiring freeze at the national level and ordered the counties to stop the process of recruiting for their newly formed agencies. At both levels the government plans reviews of ongoing staffing before new positions are filled. For the long term, the Salaries and Remuneration Commission is expected to develop new policies and procedures in accordance with international best practices in order to keep wages from spiralling. The targets set by the National Treasury are for development expenditure of at least 30% of spending and wages of 35% or less (see analysis).