The underground economy and tax productivity in Kenya, 1990-2009

Abstract

This study estimated the size of Kenya's underground economy for the period 1990 - 2009 using the fixed monetary ratio method. The study also estimated the elasticity and buoyancy of the tax system for the same period, first by using official GDP as the tax base then by using GDP inclusive of income from the underground economy as tax base. Results indicated that the size of the underground economy during this period had been declining over the years, from Ksh. 333,447 M in 1990 which was 31.76% of GDP to Ksh.68, 939 M in 2009 which was 3.67% of GDP. The tax system was found to be elastic and buoyant when measured using the official GDP as tax base but inelastic when measured using official GDP inclusive of underground income/ total GDP as tax base. The results also showed that the lagged values of GDP gave better results than the current values of GDP, giving elasticity coefficients of 1.311 and 1.279 respectively for official GDP and 0.953 and 0.841 respectively for total GDP. The study concludes that the decline in the underground economy may be due to a downward bias caused by the method adapted by the study which uses currency in circulation as a measure of the underground economy and further assumes that all underground activities are carried out in cash. The study further concludes that the size of the underground economy in Kenya is significant since it erodes the tax base and reduces revenue productivity.