Every year, Kenya foregoes more than Sh100 billion in tax exemptions in a bid to attract foreign investment.
This is despite indications the Government is losing revenue in export processing zones through incentives.
A new study by the Tax Justice Network-Africa and Action Aid International indicates that despite being the country with the most generous tax incentives in the region, Kenya was also the biggest loser in foreign direct investment (FDIs) inflows compared to Uganda and Tanzania.
According to the study, while Kenya’s FDI inflows stood at $133 million in 2010, Uganda and Tanzania $848 million and $700 million respectively over the same period.
In the study, export processing zones (EPZ) represent the largest sector where the Government is losing revenue through tax incentives.
It s emerging that many EPZ firms are closing shop after their 10-year tax holiday and re-registering under new names or relocating to other countries to avoid taxation.
EPZs employ about 30,000 people, down from 38,000 in 2005, which the study highlighted as an indication that the businesses were relocating.
Some tax benefits available to investors include zero-rated corporation tax holiday for a year and 25 per cent tax thereafter, 10-year withholding tax holiday, stamp duty exemption and 100 per cent investment deduction on initial investment applied over 20 years.
Textile industry
Dereje Alemayehu, the chair of the Tax Justice Network, said EPZ firms, notably those in textiles, accounted for 70 per cent of the exports under the US African Growth and Opportunity Act (AGOA).
At least 61 per cent of the firms operating in Kenya’s EPZ are from China, UK, US, Taiwan, Qatar and The Netherlands among other countries.
Kenya’s textile exports to the US remain limited — they represent fewer than 100 of the 6,500 eligible categories in the AGOA framework.
However, the Government is in the process of implementing special economic zones (SEZ) to expand the range.
But the SEZs are not the answer, Tax Justice Network – Africa Coordinator Alvin Mosioma argues, as they are just geographically defined regions where any company can operate tax-free.
“De La Rue (the currency printing firm) is registered in Ruaraka as an EPZ, and there is no logical explanation why it should be operating as an EPZ,” Mosioma says.
“It is a question of what the rationale of designating specific companies to operate in a geographical area where they are not paying tax,” he said.
To curb such practices, the study recommended the removal of tax incentives granted to attract FDI, particularly those provided to EPZs and SEZs, a review of all tax incentives on an annual basis, as well as tax coordination among East African Community (EAC) member countries.
Treasury is reported to be reworking its tax exemption policy, and a number of incentives are likely to be scrapped.
Estimates show that trade-related tax incentives amounted to at least Sh12 billion in 2007/08 and may have been as high as Sh47.6 billion ($566.9million).
In 2010/11, the Government spent more than twice the amount on providing tax incentives than on the country’s health budget – a serious situation when 46 per cent of Kenya’s 40 million people live on less than $1.25 a day.
“Tax holiday is a form of subsidy which distorts the market. Given a tax holiday means that you get higher profits than would be expected,” says Dr XN Iraki, a University of Nairobi lecturer.
Kills competition
“This may lead to lack of innovations as firms feel they are “protected” from competition.”
“Firms could also time their exit with the end of tax holidays so that they “harvest” maximum. This reduces long-term commitments.”
Ragnar Gudmundsson, the IMF resident representative in Kenya, says existing studies on developing countries show that while tax incentives can stimulate investment, and FDI in particular, a more important factor in determining investment and FDI is a country’s overall economic characteristics, including the quality of institutions, the size of the market, and location-specific factors, notably those linked to natural resource wealth.
“The cost of tax incentives are numerous, including budget revenue foregone, administrative and compliance costs, rent-seeking behaviour and corruption, and economic distortions that favour one industry at the expense of another,” says Gudmundsson, who has been vocal in pressuring the Government to rethink its tax incentives policy.
“There are genuine concerns about their effectiveness, but the review should take into account the bigger picture in terms of the overall economic goals of the government rather than just tax collection,” says Fredrick Omondi, a partner at Deloitte.
Omondi says the recent debate on the strength of the shilling has brought out that fact that Kenya relies ‘excessively’ on imports due to limited local production.
Local manufacturing
“Therefore, it is evident that we need to make Kenya an attractive country for productive industries. And taking into account our uncompetitive environment in terms of critical factors such as infrastructure, taxation still remains a key tool for providing incentives for sectors that are assessed as key to unlocking our economic potential,” he adds.
He says there is need to define specific parameters or set thresholds that should be attained by the beneficiaries such as employment creation (minimum number of employees, minimum wages…) in line with current priorities of the nation.
“It would be counterproductive to do away completely with tax incentives bearing in mind that we are in a globally competitive environment, and due to the mobility of certain factors of production, companies can locate their activities in other countries,” Omondi says.
“Other countries are focused on attracting investment, and we must do our bit to remain attractive.”
South Africa, for example, set aside an estimated Sh200 billion last year to provide tax incentives to promote investment and expansion in manufacturing.
“If incentives are used to correct features in the tax system that impede investment, it is preferable to correct these limitations through appropriate tax reform,” Gudmundsson said.
“If incentives are used to address weakness
es in the macro-economic or structural environment, it is preferable to implement sound policies or undertake specific reforms.”
“And if incentives are used to correct for regulatory or administrative weaknesses, it is preferable to correct and remove the deficiencies. If incentives are used for social policies, it is more efficient targeting beneficiaries directly.”
Gudmundsson says Kenya needs to be particularly wary of tax competition, where neighbouring countries or countries with similar economic structures compete to attract FDI by offering increasingly generous incentives to foreign investors.
“Such tax competition generally ends up leaving very few benefits to the host country. This is a race to the bottom that should be avoided at all costs, including by enhancing collaboration between revenue authorities at the regional level,” he adds.
“It is clear Kenya needs more foreign direct investment, especially in manufacturing. This is the lesson from East Asia,” says Wolfgang Fengler, the lead economist at the World Bank’s Kenya office.
Attract FDI
Iraki, also the MBA programme coordinator at the University of Nairobi, says to attract FDI, the county can simply make it easy to do business in Kenya by reducing bureaucracy and corruption, and investors will flock in. Investors can make much more money in a business-friendly environment than from tax holidays.
“If tax holidays must be used, they should be part of incentives, not the only incentives and should focus on long-term commitment,” he says.
“They should be based on solid economics, not politics.”
Link to the story in the Standard Media website
