The Size of the Informal Sector and Tax Revenue in Kenya

Abstract

In Kenya very little research has been carried out on the effect of the size of the informal sector on tax performance. Failure to raise adequate tax revenue from the increasing informal sector implies the government should either resort to unpopular tax rates increases or public debt. Each of these approaches has ramification on the economy. To come with relevant policies, it is important to understand the link between size of the informal sector and tax revenue performance. This paper estimates the effect of the size of the informal sector on tax revenue performance in Kenya for the period 1970-2018. On testing for stationarity, the study establishes a mixture of I (0) and I (1) variables thus suggesting the use of Autoregressive Distributed Lag model. The finding indicates that the size of the informal sector negatively influences tax revenue in Kenya. This implies that the informal sector’s output may be increasing but little tax is generated from it. The finding also has implications for the conduct of the Kenya Revenue Authority (KRA). To reduce the size of the informal sector, KRA should increase surveillance to identify economic activities that fall within the tax bracket and tap tax revenue from them.