THE EFFECT OF TAXATION ON LABOUR SUPPLY

INTRODUCTION

Since the original Meade (1978) report and indeed for some time before then, there has been
an intensive research programme focused on the way labour supply responds to incentives. The
impact of taxation on work efort is one of the main sources of inefciency of a distortionary tax
system. The magnitude of the inefciency depends on how efort reacts to incentives as well as
how the tax and transfer system changes the incentives to work and earn. More broadly, if one
is to design a tax and beneft system with some element of optimality one needs to know how
individuals react to taxes and benefts. This implies knowledge of how sensitive efort is to
incentives at diferent education groups and for both men and women. This chapter reviews the
main issues that have arisen in this voluminous research agenda and ofers what we view are
the central empirical conclusions about the impact of incentives on the supply of efort.

The key issue is how efort reacts to incentives. However, efort can be adjusted on many
diferent margins: people can change their hours of work per week or per year, whether they
work at all or not and the amount of efort they put into working. Some may also be able to
change the way they earn income (salary, dividends, capital gains) or how they consume so as to
change the tax liability. For many people hours worked is quite a good approximation to efort
and the study of the incentive efects of taxation is a study of how hours worked are afected by
taxes and transfers. However, for some higher skill individuals in particular, hours worked is not
a good measure of efort. They can adjust efort by working harder at ideas and being more
creative within a particular time period.

In addition, given the way the tax systems are designed, taxation may provide an incentive to
over-consume items that are tax-deductible or to shift earnings to tax-favoured forms. Thus the
tax incentives of the wealthy have other dimensions than hours of work and these can be an
important source of distortions in the tax system. We explain the empirical issues relating to
estimating the incentive efects on the various margins of labour/efort supply providing a
critical review of the various empirical approaches.
Incentives certainly matter, but the relevant margin difers by demographic and education
group. For some groups such as women with young children taxes and benefts can afect
whether to work or not as well as how many hours they work. For low education men tax and
beneft incentives are also important, but only for the participation decision; their hours of work
are insensitive to changes in taxes and benefts. These men either do not work at all (and up to
25% do not) or work full time — this margin is quite sensitive to how the tax and beneft system
is structured. Among full time workers there is quite a dispersion of hours worked, but taxes and
benefts have never been able to explain this efectively. For highly educated and wealthy men,
taxes do not afect whether they work or not and how many hours they put in a week or even a
year. They do however afect their total as well as their taxable income; they respond both by
reorganizing their afairs to beneft from the way diferent sources of income are taxed and by
shifting consumption to deductible sources. They can also adjust the amount of efort they put
into their work. Empirical approaches difer and data sets difer; however, we believe there is a
broad consensus in these issues, if not at the detail and at the precise numbers, defnitely for
the overall picture.

BACKGROUND AND LITERATURE

Tax is a major source of government revenue for most countries in the world. The tax structure
is commonly composed of direct and indirect taxes. Direct taxes are assumed to be paid by the
factors that produce incomes whereas indirect taxes are assumed to be paid by the house hold
that consume taxed items (Obwona and Muwonge, 2002). Direct taxes mainly include corporate
tax, income tax (Pay As You Earn (PAYE)), withholding tax, rental income tax and presumptive
income tax among others. Indirect taxes are taxes on domestic goods and services like the Value
added Tax (VAT), excise taxes on merit goods (e.g. Cigarettes and beer) and tax on imported
goods.

Compared to direct taxes, indirect taxes contribute a greater share of overall tax revenues. In
the 2009/10 tax year, the highest tax contribution came from VAT at 28%, followed by Personal
Income Tax at 22% and Corporate Income Tax at 18% to the total tax revenue of this period
(KRA 2010).
Tax is a compulsory payment that citizens of any state should pay to the authorities to allow
their governments to provide public goods, deliver merit goods and services such as education
and healthcare, promote economic growth and broad-based development, and to stabilize the
economy. Indeed, as observed by Musgrave (1997), every country imposes taxes on its citizens
and institutions for three strategic objectives: the allocation function, the distributive function
and the stabilization function. It is therefore important to state that, tax is an important
component that allows the government to promote various development activities, provide for
both public and merit goods and services, and at least stabilize the economy through various
fscal policies, of which the tax system is the most signifcant.

Tax and country’s output linkages do exist, and fscal authorities have relied on this to spur
economic growth and development. Two forms of taxes namely direct and indirect taxes have
been used to realize this goal. The former forms the backbone of this study. Direct taxes have
been in existence in Kenya since pre-independence. However, there have been various reforms
to improve productivity of various types of direct taxes. Although direct tax revenue has a direct
relation to economic growth, mixed thoughts exist to this proposition. Some proponents argue
that an objective to raise sufcient tax revenues will bolster the much needed economic growth
and development. Contrary to this, some argue that tax is a burden on their well-earned
fortunes, while to others; tax is seen as a necessary evil, to support the state and its activities.
Depending on the side one is, this all depends on the beneft one derives from the tax system
that is the net of tax payments over the respective benefts earned from the taxes they pay.

To date, Kenya’s tax revenue potential stands at approximately Ksh 900 billion (KRA, 2010),
while her expenditures as per the treasury’s 2011 budget statement stood at approximately Ksh
1.1 trillion.

Tax revenues account for well over 70 percent of Kenya’s total revenue generation, and this
clearly indicates that it is in tax that the government’s comparative advantage lies in terms of
revenue generation capacity. Therefore, any eforts geared towards enhancing the revenue
potential of the government will no doubt rest ultimately on her tax system. The government
has literally expressed its optimism and great commitment to make the vision 2030 master
plan, a reality, and this is a great inspiration to the Kenyan people. Therefore, for its full
implementation, massive funding for various projects is a prerequisite and direct taxes would
play a critical role.

In this, Kenya is currently one of the countries of the world that has, due to highest tax rates, a
narrow tax base and concerns over its unfair distribution of the tax burden, not mentioning the
complex tax codes (KIPPRA, 2006). While substantial tax reforms have already been put in place
over the years, there still exists greater scope for improvement, more so direct taxes, to
enhance the revenue capacity for the country. Thus improved tax structures in the collection of
direct taxes allows for greater revenue generation, while not making the tax system more unfair
as is the case currently.

CHAPTER TWO: LITERATURE REVIEW

The impact of fscal policy on the economy has been an issue of concern for not only
economists but also policy makers. Governments use fscal policy to control the level
of activity in the economy. Fiscal policy is the use of taxes and government spending by
the state to control the economy (Truett and Truett, 1987). The state uses
contractionary fscal policy (cut in government expenditure and increase in taxes) to
reduce the economic activity, whereas expansionary fscal policy (increase in
government expenditure and tax cuts) is used to increase economic activity. In
developing countries, governments use fscal policy to increase rate of investment and
employment, achieve economic stability and redistribute income (Jhighan, 2004).

The relationship between taxes and economic performance however remains an issue
of debate among scholars, who are far from reaching a consensus. The theoretical and
empirical literature is outlined below.
2.1 Theoretical literature

Adam Smith (1776) in The Wealth of Nations recognized the important role of taxes in
the economy and gave the characteristics of a good tax system (Canons of taxation) as
certainty, equity, convenience and economy. Musgrave and Musgrave (1989) defned a
good tax structure as one that yields adequate revenue, is equitable, causes minimal
distortion and facilitates stabilization and growth. Keynes (1936) advocated for
government intervention in the economy. Keynesian economics support the fact that
the aggregate demand influences the level of output in the economy. The government
through fscal policies can influence aggregate demand in the economy.

Keynes advocated for tax cuts to stimulate the economy, and tax increase to dampen
the economy. During a depression, he advocates for government intervention by
increasing government expenditure and tax cuts to stimulate the economy.
Monetarists are however opposed to this view and believe that the money in
circulation is what determines the level of output in the economy and tax policy is
inefective.

The sources of economic growth have been explained in growth models such as the
Neo-classical growth model and endogenous growth models. Efect of taxes on growth
has been incorporated in many growth models including Neo-classical economic
growth models, which state that growth is not influenced by policy decisions (Renelt,
1991). Solow neo-classical growth model suggests that taxes afect only the level of
income but not the rate of economic growth (Solow, 1956). Changes in tax rate will
only cause temporary changes, during the period of transition to steady states. Once
steady state is achieved, only technical progress will influence economic growth.
Endogenous growth models do not support Solow’s assumption that growth is only
influenced by technical progress (Renelt, 1991). Endogenous growth models allow
growth rate to be determined within the model; growth is influenced by economic
policy. Therefore, in this growth model, taxes afect the long run growth rate, through
accumulation of physical and human capital. Changes in tax policy will influence the
economic growth.

According to economic theory, the economy grows through capital formation, which
comes from resource mobilization. Taxes on the resources will discourage production,
hence capital formation thereby hurting the economy. Taxes afect capacity output
through work efort, private sector savings and private investment (Musgrave and
Musgrave, 1989). Mintz and Wilson (2000) fnd that productivity of factors influence
growth. Taxes can reduce this productivity in various ways. Taxes distort economic
decisions resulting in inefcient use of resources. Taxes also reduce the incentive to
work and to improve work skills. Taxes may also discourage innovations and adoption
of new ideas, since more productivity will increase tax liability and people want to
reduce their tax liability as much as possible. High taxes may also result in capital flight.
Resources will shift from countries with high taxes to lower tax countries. High
corporate taxes lower the rate of return thus discouraging investment hence deterring
economic growth. High personal income taxes will discourage savings, which will
reduce human capital formation hence impeding growth. Leibfritz et al. (1997) support
the view that taxes afect economic growth through its distortionary efects on savings,
physical and human capital formation and labor supply.

Theoretical literature supports the fact that taxes hurt the economy (Poulson and
Kaplan, 2008). Therefore, a state can lower taxes to promote growth. Engen and
Skinner (1996) support the fact that lowering taxes has positive efect on growth.
However, they note that, tax cuts create a revenue gap and the state has to raise
revenue from other sources to fll the gap. Taxes can also be good for the economy if
they provide more and better public goods and services to the citizens, thereby
increasing productivity hence economic growth (Leibfritz et al., 1997).

2.2 Empirical literature

Empirical literature gives difering views on the efect of taxes on economic

performance. Debate on whether taxes impact negatively or positively on the
economy remains inconclusive. The direction of their relationship also remains unclear.
Most empirical studies on taxation and economic performance are carried out on a
cross country level. A few exist on country specifc level.

The GDP of an economy is its total output usually a total of consumption, government
purchases, investment spending, and net exports, as shown:

Y=C+G+I+NX

Where, Y is national output/income, C is consumption, G is government purchases, I is

investment spending, and NX is net exports. A change in income tax afects national
income (Mankiw, 1993). A decrease in taxes has a multiplier efect on income. It raises
disposable income, therefore, increases consumption and planned expenditure leading
to a greater increase in national income. Income tax can also reduce the multiplier
efect of an increase in consumption or government purchases on national income.
However, this efect is on the short run.

Scholars have developed models to explain causes of long run growth of an economy.
Engen and Skinner (1996) using a model similar to that of Solow (1956) explain how
taxes afect economic growth. Economic growth rate is determined by the growth of
the output of the economy.

Researches on the efect of specifc taxes on the economy also exist. Djankov et al.
(2010) investigates the efect of corporate taxes on investment and entrepreneurship
using panel data for 85 countries. The authors fnd that efective corporate tax rates
have a signifcant negative correlation to investment, foreign direct investment and
entrepreneurship. The corporate taxes are correlated to investment in the
manufacturing sector but not in services sector. High corporate taxes will therefore
reduce investment hence lowering productivity adversely afecting economic growth.
These fnds are similar to those of a study by Lee and Gordon (2005), who fnd
corporate taxes to be negatively correlated with economic growth. Low corporate
taxes encourage entrepreneurial activity hence promoting economic growth.

Poulson and Kaplan (2008) investigate the impact of state income taxes on economic
growth in the United States. The period of study was from 1964 to 2004. Their model
is an endogenous growth model of a linear form. They regress relative growth rate on
relative marginal tax rate, relative regressivity, income tax dummy, relative per capita
personal income in the initial year, and regional dummy. They fnd that high marginal
tax rate creates a disincentive to work and invest hence lower economic growth. Their
fndings also suggest that all taxes have a signifcant negative efect on economic
growth, but the impact income tax is more than that of other taxes. States with more
regressive tax system have higher growth rates than those with more progressive tax
systems.

Easterly and Rebelo (1993a) using a panel data of 28 countries for the period
19701988, in an empirical study on fscal policy and economic growth, fnd no solid
evidence that taxes afect growth. The authors fnd it difcult to isolate efects of taxes
on growth from those of government expenditure. Other fndings are that poor
countries rely heavily on international trade taxes, while developed countries rely on
income taxes. Easterly and Rebelo (1993b), point out that from growth theories
income taxes impact negatively on economic expansion; income taxes directly
influence economic growth.

Plosser (1992) fnds a negative correlation between the level of taxes on income and
profts as a share of GDP, and growth of real per capita GDP. Taxes on income and
profts depress economic growth. The study was conducted on 24 OECD countries for
the period 1960-1989. Manas-Anton (1986) examines the interrelationship between
output growth and the reliance of the tax system on income taxes in developing
countries. The author uses cross country to estimate multiple regressions containing
determinants of growth. The regressions showed that the ratio of income taxes to total
tax revenue and the output growth rate are negatively related, but this does not hold
for all specifcations, hence negative relationship between growth rates and the
reliance of a country on income taxes cannot be asserted with confdence. Skinner
(1988) investigates the efect of government spending and taxation on output growth,
using data from 31 African countries for the period 1965 to 1982. The author fnds that
income, corporate, and import taxes will lead to greater reductions in the growth of
output than export and sales taxes.

King and Rebelo (1990) use a simple endogenous model to show the efect of income
taxes on growth. They fnd that, an increase in income tax by 10 percent causes a drop
in economic growth by 2 percent. High income taxes will lower the rate of return,
which reduce the rate of capital accumulation thus lowering long run growth rates.
Engen and Skinner (1992) using data for 107 countries for the period 1970-1985, fnd
that fscal policy can be both good and bad for growth. The distortionary efects of
taxes hurt economic growth, while public goods and infrastructure promote economic
development. Their empirical results reveal a signifcant and negative impact of fscal
policy on output growth rates in the short-term and the long-term. They also point out
that taxes on labor income may impact output growth diferently from corporate,
interest and trade taxes. The efect of labor tax on output growth depends on labor
supply elasticity in the short term; in the long run the efect is ambiguous.

Engen and Skinner (1996) have suggested that replacing the income tax with a
consumption tax, can increase work efort, savings and investment, thus boosting
economic growth. They show that increase in taxes rates in the US are accompanied by
a decline in economic growth rate. Their empirical estimation reveals a negative
relationship between taxes and growth, which is not very strong, but they note that
the small efect can make large cumulative impact on the economy. Cashin (1995)
investigate the impact of government spending and taxes on economic growth using
an endogenous growth model, using panel data for the period 1971-1988, for 23
developed countries. The author fnds that distortionary taxes hamper growth while
provision of public capital and transfer payments promote growth. Leibfritz et al.
(1997) using a cross country analysis for OECD countries, over a period of 35 years, fnd
that an increase in the average tax rate by 10 percent reduced growth rate by 0.5 per
cent. Using simulation, they fnd that reduction in corporate taxes has the largest
impact on output, reduction in labor taxes increase employment while consumption
taxes have the least efect.

Bahl and Bird (2008) analyze the characteristics of tax policy in developing countries
for the past 30 years using cross country data. They fnd that, for the developing
economies, revenue from international trade taxes has declined due to opening up of
the economy, and personal income taxes have been playing a limited role due to
existence of large informal sector that is difcult to tax. They propose that
governments should not overtax to ensure that variables such as savings, investment
and work efort that promote growth are not adversely afected. Having a broad tax
base, that encompasses both income and consumption taxes, is good for the economy.

A study by Chang (2006) use an intertemporal optimizing growth model to examine

whether relative wealth induced status determines how consumption tax afects
growth. The fnding was that, when individuals care about their relative wealth, an
increase in consumption tax will increase capital growth and consumption hence
improving economy’s long run growth rate.

Slemrod (1995) carries out a cross country study on government involvement,

prosperity and economic growth. The author fnds a strong positive association
between taxes and economic performance in the developed countries. This is
demonstrated this using time-series data for real GDP per capita and the ratio of taxes
at all levels of government to GDP, for the period 1929-1992 for the United States.

Among the OECD countries, there is no obvious correlation for either tax or
expenditure and prosperity. However, there is a positive correlation when high-tax
OECD countries and the rest of the world are included in the sample. Slemrod also
shows a signifcant negative partial association between growth and a measure of
government involvement, by comparing tax-to-GDP ratio and the ratio of government
expenditures to GDP with growth for OECD countries. The author concludes that, there
is not much persuasive evidence to show whether government involvement influence
the economic performance either positively or negatively.

Mendoza et al. (1996) examine the efect of tax policy on growth using endogenous
growth model. They fnd that changes in the tax policy relating to private investment
are economically and statistically signifcant, but are not sufciently strong to influence
growth. This study supports Harbeger (1964) who, using a growth accounting
framework, shows that changes of both direct and indirect taxes have negligible efects
on growth of output. This is because taxes have negligible efects on the growth of
labor supply and on labor's income share thus savings and investment are not large
enough to support economic growth.

The IMF studies (Goode, 1984) analyze the relationship between taxes and economic
performance. The main variables in their model are tax ratio and per capita income.
Tax ratio is the ratio of total taxes to GDP. Openness of the economy and economic
structure are included for control. Openness of the economy is measured by the level
of foreign trade; it is the total of imports and exports expressed as a ratio of GDP. The
economic structure is measured by the relative size of agriculture and mining sector.
The IMF studies are cross country studies. When the developing countries are taken
together with developing countries, the per capital income is found to be positively
related to the tax ratio, with a high correlation coefcient (0.61, 72). However, when
the developing countries are taken separately, the correlation between tax ratios and
per capita income is weak and doubtful, (Goode, 1984). The efect of per capita
income on tax ratio is positive but doubtful for developing countries. Openness of the
economy has a positive impact on taxes, while agriculture has a negative relationship
to taxes because it is hard to tax and sensitive sector.

Studies on taxation in Kenya have covered aspects like tax performance, indirect taxes
and revenue productivity among others, but a few have touched on taxes and growth.
A study by Wawire (1991) on tax performance in Kenya analyzes tax ratios, tax efort
indices, tax ratio buoyancy, and per capita income elasticities of various tax ratios. The
fndings were that tax ratios increase with per capita income, volume of international
trade, economic activity such as manufacturing and mining. The author concludes that
tax ratio is greatly determined by the economic structure. Otieno (2003) analyzes the
impact of indirect taxes on economic growth in Kenya using a simplifed endogenous
growth model. The uses time series data for the period 1970 – 2000. The results
confrm that indirect taxes cause distortion in market decisions and consequently
impact negatively on the economy.

Gachanja (2012) did a study on economic growth and taxes in Kenya, using time series
data for the period 1971-2010. The study reveals a positive relationship between the
economic growth and taxes. All the taxes (income tax, import duty, excise duty, sales
tax and VAT) show a positive correlation to GDP, with income tax having the highest
efect. Gachanja (2012) also tests for the direction of causation of the variables using
Granger Causality test, and fnds reversal causality between economic growth and
excise tax, and a unidirectional relationship between income taxes and economic
growth, and economic growth and VAT. Gachanja (2012) points out that diferent uses
of tax revenue afect growth diferently. The model however fails to capture variables
other than taxes that influence GDP, such as government expenditure and investment.

Overview of Literature

The debate on the impact of taxes on the economy has gone on through the years
without reaching a consensus. While most theoretical literature identifes fscal policy
particularly taxes as a driver of economic growth and development (Musgrave and
Musgrave, 1989), the existing empirical literature fails to give a defnite direction on
how taxes influence the economy. The direction of causation of taxes and growth is not
clear. Endogenous growth models have been used to study how taxes influence
growth, on a cross country level. Most of the empirical studies reveal that taxes
adversely afect the economy. A few studies have isolated the impact of income taxes
on the economy such as the study by Poulson and Kaplan (2008) which found income
tax having a signifcant negative impact on economic growth. Other studies covered
the efect of income taxes together with other taxes, on the economy. Studies by
Easterly and Rebelo (1993b), Plosser (1992), King and Rebelo (1990), and Engen and
Skinner (1992) fnd a negative relationship between income taxes and growth. Lee and
Gordon (2005) fnd a negative relationship between corporation taxes and growth.
Manas-Anton (1986) and Engen and Skinner (1996) fnd a weak negative correlation
between income tax and growth. Gachanja (2012) fnds a positive relationship
between income tax and GDP. According to Skinner (1988) and Poulson and Kaplan

(2008), income taxes will lead to larger reductions in growth than other taxes.

Empirical studies reveal positive, negative or weak correlation between taxes and
growth. Gachanja (2012) found a positive relationship between taxes and growth.
According to Chang (2006) consumption tax will increase economic growth when
individuals care about their wealth induced status. The negative relationship between
taxes and economic growth has been supported by many authors: Manas-Anton
(1986), King and Rebelo (1990), Plosser (1992), Engen and Skinner (1992), Cashin
(1995). However, Slemrod (1995) fnds a positive correlation, no correlation and also a
negative correlation. Mendoza et al. (1996) support Harbeger’s neutrality which
proposes that tax policy has no impact on the economic growth. Evidence supports
that taxes have an impact on the economy; high taxes are bad for economic growth
with corporate taxes having the highest impact followed by individual income taxes,
and consumption and property taxes having less impact. McBridge (2012) attributes
this to the fact that economic growth is a result of production, innovation, and risk
taking.

Studies done on taxation in Kenya have not focused on its impact on the economic
performance. Most studies have dealt with tax reforms, revenue productivity and
specifc taxes such as sales and excise tax (Osoro, 1993; Njoroge, 1993; Gatuku,
2011; Oketch, 1993; Mwanamaka, 1997). A study by Gachanja (2012) focused on the
efect of all taxes on growth in Kenya. There is no study that has isolated the impact of
income taxes on economic performance in Kenya. The income tax to total tax revenue
 ratio has continued to increase compared to other taxes, making it a signifcant
variable in economic decision-making. Studies on income tax are important to policy
makers and other economic agents. This paper adds to the existing stock of
knowledge and tries to fll the information gap, by exploring the
efect of income taxes on the Kenyan economy.

Trend in Personal Income Tax

Income tax was introduced in Kenya in year 1921. A large proportion of tax payers failed to pay,
as the Government chose to abolish rather than enforce the law. In 1954, the rates of personal
income tax were set at sh.20 for anyone earning less than 60 pounds, for earnings between
60120 pounds this was set at sh.40 and for earnings over 120 pounds at sh.60.
Personal income tax is a tax on income from individual businesses and wages. At the end of
each year, individual owners of businesses lodge income tax returns for their businesses.
Income from employment is subject to Pay As You Earn (PAYE). Personal income tax and PAYE
are charged at the same graduated scale. The current income tax brackets are: 10 percent on
the frst Ksh 121,968; 15 percent on the next Ksh 114,912; 20 percent on the next Ksh 114,912;
25 percent on the next Ksh 114,912; and 30 percent on all income over Ksh 466,704 (annually).

Taxes, Benefits and Labour Supply.

We start by considering the basic labour supply model which is at the heart of the large
literature on the incentive efect of taxation. Labour supply models express the tradeoff
between market work and leisure. Under suitable conditions on preferences, the labour supply
function depends on a measure of non-labour (or “unearned”) income denoted by µ and the
marginal wage rate w, which represents the amount earned in real terms for an extra hour of
work. Non-labour income may include any source of income that is unrelated to the work
decision of the person in question. Thus it cannot include means-tested transfers, but it can
include universal benefts such as the UK’s child beneft. Labour supply can also depend on a
collection of background and family characteristics which afect one’s tastes for work and which
we summarize as Z. Thus the Z variables can include the number and ages of children, education
level etc. The relationship expressed is just a reflection of the way individuals are willing to trade
of leisure for pay at a given period of time. Now we need to see how the efects of taxes are
incorporated within this framework. We will then discuss the role of fxed costs of work and
dynamics or intertemporal trade-ofs, making the framework richer for policy analysis.

Research objectives
This paper seeks to determine the relevance of income taxes to the Kenyan labour market. The

general objective of the paper is to determine how income taxes afect economic performance

in Kenya.

The specifc objectives are:

i) Investigate the trend of income tax and labour performance

ii) Analyze the relationship between income tax and economic performance
iii) Recommend income tax policy that will improve economic performance in Kenya.