State think tank: Raising VAT risks driving firms to informal sector

New findings from a state-backed think tank suggest that Kenya’s 16 per cent Value Added Tax (VAT) rate may be pushing businesses to operate informally.

While not seen as prohibitive for the business environment, the findings from the Kenya Institute for Public Policy Research and Analysis (Kippra) suggest that the 16 per cent rate is at the higher end of the optimal threshold, estimated at 16.3 per cent.

The research paper published in July provides a model of what should be the ideal VAT rate for Kenya, giving a baseline of 10.25 per cent, and 16.3 per cent at the upper end.

It says the 10.25 per cent optimal VAT rate highlights the potential for revenue maximisation at a lower rate under ideal conditions.

“The 10.25 per cent rate represents an ideal scenario in a 'pure' economy, where minimal inefficiencies and a broad tax base allow for revenue maximisation at a lower rate,” explains Kippra in the research paper titled Prospects and Optimal Level for VAT.

The paper analyses the possibility of Kenya lowering the VAT rate as an incentive to grow the economy.

One of the suggestions that could make this happen, it says, is to bring on board more of the informal enterprises into the mainstream.

This would enable the government to reduce its reliance on VAT as it would have a large pool of taxpayers, hence should consider slashing the 16 per cent to a lower figure.

“To move towards this scenario, Kenya needs to focus on broadening the VAT base by minimising exemptions and formalising the informal sector, strengthening compliance through robust enforcement mechanisms, and leveraging digital tools, such as i-Tax and TIMS,” the research paper says.

The paper says that real-world factors such as gross domestic product (GDP), economic growth, and technology adoption shift the optimal rate to 16.30 per cent.

This suggests that a VAT rate of 16 per cent is reasonable and appropriate in the Kenyan context.

“Therefore, Kenya’s current VAT rate is well-positioned for revenue generation without moving into the prohibitive range, where rates would discourage economic activity, reduce compliance, and lead to diminishing returns,” says Kippra.

To further optimise VAT performance, the think tank says policymakers can focus on structural reforms and technological advancements rather than increasing the rate.

In the year ended June 2026, the taxman collected Sh355.3 billion in domestic VAT, a growth of 8.5 per cent.

Kippra says VAT, in particular, is pivotal to government coffers due to its high revenue-generating capacity and prevalence in global consumption tax systems.

“However, in Kenya, like many developing economies, administrative inefficiencies, exemptions, and a substantial informal economy—accounting for an estimated 84 per cent of total output in 2024—significantly undermine VAT revenue generation,” the think tank says.

Kippra references Kenya Revenue Authority (KRA) figures which show a VAT collection gap exceeding 20 per cent.

It adds that recent government initiatives aimed at enhancing VAT and excise revenue collection have yielded positive preliminary outcomes.

Yet, Kippra says despite these tax reforms and increased efforts, VAT revenues have not reached desired levels, contributing only five per cent of Gross Domestic Product (GDP) on average.

“This shortfall has kept overall tax revenue at around 20 per cent of GDP between 1990 and 2022, below Kenya’s Vision 2030 target of 25 per cent,” reads the study.

“This gap underscores the ongoing challenge of realising Kenya's fiscal and developmental aspirations through optimised tax policy and administration.”

Kenya has toyed with the idea of raising as well as lowering VAT. For instance, Kenya’s VAT is lower compared to its East African Community (EAC) counterparts, which stands at 18 per cent.

However, Kippra warns of the consequences of raising VAT beyond the optimal levels.

It states that at 16 per cent, Kenya’s VAT rate is close to the upper bound of this optimal range, indicating that it is effective but risks entering the prohibitive range if increased further.

“In this range, higher rates could suppress consumption, increase evasion, and reduce compliance, undermining revenue generation. As VAT rates exceed the optimal level, consumers and businesses may change their spending and production habits to avoid the tax, leading to a decline in the tax base.

It adds: “For instance, high VAT rates can incentivise informal economic activities or reduced consumption of taxed goods and services.”

In the Medium Term Revenue Strategy 2024/25-2026/27, the National Treasury notes that VAT revenue as a percentage of GDP declined from 4.6 per cent in financial year (FY) 2013/14 to 3.9 per cent in FY 2022/23.

This, it says, is largely attributed to tax exemption and zero rating of some goods that do not conform to international best practices.

The document says to improve this performance, the government will reconsider the preferential rates and instead adopt a standard rate for all taxable supplies.

“Preferential rates contribute to the dismal performance of VAT and create discrimination against other taxable supplies leading to market distortions. In addition, differentiated rates create a justification for taxpayers to lobby the Government to extend preferential rates to other goods and services,” says National Treasury in the document.