Kenyan tax risks

Kenyan President Uhuru Kenyatta on 14 September resubmitted the Finance Bill 2018 to the National Assembly, proposing that legislators accept a reduced VAT levy on petroleum products rather than withdrawing this altogether. The revised bill is likely to be approved, with its scaled-back tax measures likely to result in government revenue shortfalls that delay the financing and construction of new development projects.

• Kenyan President Kenyatta on 14 September resubmitted revised tax and spending measures to the National Assembly following opposition to the original bill from across the ruling Jubilee party and main opposition Orange Democratic Movement in parliament.
• An 8% value-added tax on petroleum products is likely to be approved, along with a total USD529.9 million in compensatory budget cuts to offset the loss of higher initially proposed fiscal revenues.
• Despite objections from the government and International Monetary Fund recommendations to remove the measure, the interest-rate cap on bank lending is unlikely to be repealed due to continued strong parliamentary opposition.
• Revenue shortfalls are still likely as the government seeks to cover public-debt repayments, increasing the risk of delays to the financing and construction of several infrastructure development projects in 2018.

President Uhuru Kenyatta on 14 September resubmitted Kenya's Finance Bill 2018 to parliament, proposing that legislators accept a reduced value-added tax (VAT) on petroleum products of 8%. On 29 August, the National Assembly had approved the total removal of a 16% VAT on such goods. Kenyatta also requested the reintroduction of a banking turnover tax of 0.05% (on transactions exceeding USD4,950), which legislators had rejected. A total of USD529.9 million in cuts to government expenditure was also proposed to compensate for tax revenue lost following the legislative changes. The president argued that these measures were necessary to finance ongoing development projects, as well as affordable housing and medical services under the government's 'Big Four' policy agenda.

Members of parliament had also rejected amendments to the Banking Act that would have removed Kenya's cap on banks' lending rates. Legislative proposals that were accepted included expanding the mandate of the Central Bank of Kenya (CBK) to include licensing and supervision of mortgage refinance companies, which provide long-term loans to primary mortgage lenders, through an amendment to the CBK Act. Also accepted was an amendment to the Proceeds of Crime and Anti-Money Laundering Act, which requires banks to apply enhanced due diligence to business relationships and transactions involving countries identified as carrying higher risk of money laundering and terrorism-financing activities.

Parliamentary agreement

A minimum two-thirds' share of MPs is necessary to reject the revised Finance Bill as submitted by the president. Kenyan parliamentarians convened 18 September for the first of two special sessions to discuss the changes. The next session will be held on 20 September. The ruling Jubilee party, which controls a 49% share of seats in parliament, announced that its members had agreed to approve the proposals. The main opposition Orange Democratic Movement (ODM) party, which controls an 18% share of seats, also announced its support. The ODM specified that the VAT levy should be reviewed again after one year, although ODM leaders are unlikely to require that this condition is written into the amended legislation.

Fiscal pressure

President Kenyatta is trying to sustain his government's broader commitment to the fiscal consolidation objectives underlying the current budget. This aims to slow down public-debt accumulation and bring the overall fiscal deficit down to 5.7% of GDP in 2018/19 from 7.2% of GDP in 2017/18. This is to be achieved through domestic revenue mobilization efforts that leverage augmented tax policies, alongside prioritized expenditures orientated towards the 'Big Four' policy agenda. While it is too early to determine whether the government's consolidation push is strongly on track, the concessions proposed in response to opposition against high-profile tax increases heighten the risk of a shortfall in actual total revenues collected against initial projections despite the positive economic growth environment. Planned expenditure rationalization to account for tax revenue losses may not be sufficient to mitigate fiscal risks. We anticipate that additional cuts may be necessary, especially should unanticipated budget execution challenges materialize. The need to cover over USD7.94 billion (KES800 billion) in public-debt repayments - spanning domestic obligations, scheduled Eurobond debt service, and loans from commercial creditors - increases pressure on the government either to secure additional funds or squeeze public spending further.

Outlook and implications

We assess that there is sufficient support within the ruling Jubilee party and main opposition ODM for parliament to approve the revised proposals as they currently stand. If Deputy President William Ruto chooses to publicly oppose the VAT levy on fuel, then this would indicate a split in the Jubilee party's support for the revised Finance Bill. In this scenario, a two-thirds' majority necessary to oppose the president's changes would probably only be likely if a majority of ODM legislators reject leader Raila Odinga's decision to support the 8% levy. A key indicator for this outcome would be the unlikely move by ODM deputy leader and Mombasa county governor Hassan Joho to oppose the tax changes before the parliamentary vote on 20 September. Joho's supporters from the southeastern Coast region view him as Odinga's successor to lead the ODM ahead of the 2022 general election, but have increasingly voiced concern than a leader will be chosen from Odinga's own stronghold in the western counties around Lake Nyanza.

If the Finance Bill were to be approved in its latest form, the extra fiscal revenues it would generate should reduce the need for the Treasury to cut government expenditure targeted towards financing existing development projects. Even then, several proposed projects probably would face reduced budgetary allocations and resulting implementation delays, including the Konza ICT City (with a resulting threat of cancellation to associated procurement contracts), Last Mile Connectivity project, construction of a second runway at the Jomo Kenyatta International Airport, and road construction projects earmarked for rural areas. Delays are also likely to affect construction of the proposed 267-kilometre phase 2B of the Standard Gauge Railway from Naivasha to Kisumu, after Kenya failed to secure an anticipated USD3.8 billion in grants and loans from the Export-Import Bank of China following the triennial Forum on China-Africa Cooperation (FOCAC) on 3-4 September. However, if an independent performance review is undertaken, then Chinese officials are likely to reconsider financing options and grant final approval. Newly proposed development projects will remain subject to a one-year moratorium that was imposed by a presidential decree issued on 20 July.

As we have previously assessed, Kenya's bank interest-rate cap is unlikely to be repealed because of strong opposition across the two main parties. This is despite the Treasury's failed effort to prompt its removal last June. It also indicates little attention given to concerns expressed by the CBK and reiterated by the International Monetary Fund about likely adverse implications for commercial banks' lending patterns and the cap's impact on effective monetary policy transmission into the real economy. Private-sector credit growth remains broadly subdued despite a slight pick-up this year to 4.3% year on year (y/y) in June, from 2.1% y/y in February. We expect this upward climb to continue given the CBK's eased monetary policy stance - anchored by a cumulative 100-basis-point cut in the central bank rate to 9% during the first seven months of 2018 - alongside optimism on revived economic activity. We assess that real GDP growth will increase to 5.1% in 2018, following a forecast decline to an estimated 4.2% in 2017. The recovery has largely resulted from the end of business disruption caused by the disputed elections last year, which resulted in a re-run of the presidential election in October 2017.

Nevertheless, its trajectory is likely to be gradual at best, reflecting the persistence of observed shifts in commercial banks' lending patterns following the interest-rate cap's introduction, which include more selective private-sector lending and increased investment in government securities. The CBK has already expressed its intention to encourage adjustment to the distribution of lending favoring weaker credits and smaller firms by measures to encourage more risk-based pricing and mitigation of credit risks, but it is not yet clear how these would encourage lending to higher-risk borrowers whose loans are made unattractive for banks by their capped return.

Meanwhile, through the Kenya Bankers' Association, the banking sector is challenging the banking transaction tax in the High Court. If the tax is implemented, we expect it to diminish already-low profitability in the sector (the return on average assets declined from 3.9% in 2016 to 2.7% in the first quarter of 2018), impairing banks' ability to build up capital buffers from retained earnings, and increasing their vulnerabilities to further external shocks.