6.0 Tax systems and policies

6.1 Introduction 

In the previous chapter we covered tax planning. In this chapter we will lay emphasis on developing 

tax systems and policies. Tax systems are the frames on which a country’s revenue collection is 

built. The chapter will assist the student understand the various types of tax systems and be able 

to recommend a viable tax system based on International best practices.

In the next chapter we shall look at professional ethics in taxation.

6.2 Objectives

After this chapter the students should have understood the following concepts:

• Types of tax systems 

• Role of taxation in economic development 

• Design of a tax policy 

• Criteria for evaluation of a tax system 

• Tax reforms and modernisation of tax systems 

6.3 Exam Context 

This is a new topic introduced with the review of the syllabus. Questions in this topic are likely to 

be theoretical and could test a candidates’ understanding of tax systems, reforms, modernisation 

of the tax systems and design of a tax policy.

6.4 Industrial Context

This topic will enable economic experts understand the various tax systems and be in a position 

to advise accordingly. It will also help students understand the role of taxation in economic 

development.

6.5 Key definitions

Tax system: This is an organised way in which the government collects tax from its citizens. 

It involves the various approaches, structures and policies adopted over time and relating to 

taxation and revenue generation.

Tax policy: is the government's approach to taxation, both from the practical and normative

side of the equation. Policymakers debate the nature of the tax structure they plan to implement 

(i.e., how progressive or regressive) and how it might affect individuals and businesses (i.e., tax 

incidence).

Tax reforms: These are changes or amendments of the tax system with the general objective of 

revenue adequacy, economic efficiency, equity and fairness and simplicity.

Tax Modernisation: These are reforms implemented to ensure that tax systems are kept 

abreast with technological advances. This improves tax collection and ensures efficiency in the 

tax system.

6.6 Types of tax systems

Generally, there are two major types of tax systems.

• Single or unified tax system

• Multiple tax system.

Unified tax system

A unified tax system has only one form of tax. For example, in some countries, turnover tax is the 

only tax upon income of a person. A unified tax is a fixed tax that is paid for a given period of time, 

usually one year, to guarantee business entity of all legal protection for the period.

It caters for tax liabilities that a business entity is required to pay in order to acquire the legal 

protection for a specified period of time usually one year. The regime is usually graduated into 

tax schedules defined on the basis of either profitability or employment levels of business entities 

such that the higher the level of employment or profitability, the higher the amount of unified tax 

payable.

Multiple tax system

It comprises a variety of taxes that are applicable at the same time on the income of a person. 

In Kenya, for example, we have a multiple tax system since there are many taxes applicable 

including personal tax, corporation tax, withholding tax, compensating tax, turnover tax, Value 

Added Tax, Customs and Excise tax ..

A multiple tax system may be preferred to a single tax system for the following reasons:

i) Sufficient revenue

A government implementing a multiple tax system is able to collect sufficient revenue 

due to a wide tax base

ii) Desire to regulate externalities

A country implementing a multiple tax system will be in a position to regulate externalities 

whenever they arise e.g. a country may impose heavy import duty to protect local 

industries

iii) Minimise incidences of tax evasion

Since a multiple tax system has a wide tax base it is able to minimise tax evasion by 

bringing every taxable person into the tax blanket

6.7 Role of taxation in economic development

The role of taxation and fiscal policy in the development strategy of a country has to 

be viewed in the background of the functions a taxation system performs. The main 

functions of taxation in relation to economic are as follows.

a. Economic stability

Taxes are imposed to maintain economic stability in the country. During inflation, the government 

imposes more taxes in order to discourage the unnecessary expenditure of the individuals. 

During deflation, taxes are reduced in order to enable the individuals to spend more money. In 

this way, the increase or decrease of tax helps to check the big fluctuations in the prices and 

maintain economic stability.

b. Raise revenue

The revenue is required to pay for the goods and services which the government provides. These 

goods are of two types – public and merit goods. Public goods, such as defense and police are 

consumed collectively and no one can be prevented from enjoying them if he wishes to do so. 

These goods have to be provided by governments. Merit goods, such as education and medical 

care, could be, and often are, provided privately but not necessarily in the amounts considered 

socially desirable and hence governments may subsidise their production. This may be done for 

a variety of reasons but mainly because the market may not reflect the real costs and benefits of 

the production of a good. Thus, the public may be subsidised because the market does not take 

account of all the costs and benefits of the public transport system.

c. Pay interest on national debt

Taxes are also levied by the government to pay interest on national debt.

d. Fair redistribution of income

A major function of taxation is to bring about some redistribution of income. First, tax revenue 

provides the lower income groups with benefits in cash and kind. Second, the higher income 

groups, through a system of progressive taxation, pay a higher proportion of their income in tax 

than the less well-off members of the society.

e. Protection policy

Taxes are also imposed to give protection to those commodities which are produced in the 

country. The government thus imposes heavy taxes on the import of such commodities from the 

other countries. In the view of these taxes, the individuals are induced to buy local products.

h. Social welfare

The government imposes taxes on the production of those commodities which are harmful to 

human health e.g. excise duty on wines, cigarettes among others.

i. Optimum allocation of resources

Taxes are also imposed to allocate resources of the country for their optimum use The amounts 

collected by the government from taxes are spent on more productive projects. It means the 

resources are allocated to achieve the maximum possible output in the given circumstances.

6.8 Design of a tax policy 

Tax policy challenges facing developing countries 

Taxation is the only practical means of raising the revenue to finance government spending on 

the goods and services that the citizens of a country demand. Setting up an efficient and fair tax 

system is not easy, particularly for developing countries that want to become integrated in the 

international economy. The ideal tax system in developing countries like Kenya, should raise 

essential revenue without excessive government borrowing, and should do so without discouraging 

economic activity and without deviating too much from tax systems in other countries. 

Developing countries face formidable challenges when they attempt to establish efficient tax 

systems:

i. Most workers in developing countries are typically employed in agriculture or in small, 

informal enterprises. As they are seldom paid a regular, fixed wage, their earnings 

fluctuate, and many are paid in cash, "off the books." The base for an income tax is 

therefore hard to calculate. Nor do workers in these countries typically spend their 

earnings in large stores that keep accurate records of sales and inventories. As a result, 

modern means of raising revenue, such as income taxes and consumer taxes, play a 

diminished role in these economies, and the possibility that the government will achieve 

high tax levels is virtually excluded. 

ii. It is difficult to create an efficient tax administration without a well-educated and 

well-trained staff, when money is lacking to pay good wages to tax officials and to 

computerise the operation (or even to provide efficient telephone and mail services), 

and when taxpayers have limited ability to keep accounts. As a result, governments 

often take the path of least resistance, developing tax systems that allow them to exploit 

whatever options are available rather than establishing rational, modern, and efficient 

tax systems. 

iii. Informal structure and financial limitations of the economy in many developing countries 

and hinder the statistical and tax offices from generating reliable statistics. This lack of 

data prevents policymakers from assessing the potential impact of major changes to 

the tax system. As a result, marginal changes are often preferred over major structural 

changes, even when the latter are clearly preferable. This perpetuates inefficient tax 

structures. 

iv. Income tends to be unevenly distributed within developing countries. Although raising 

high tax revenues in this situation ideally calls for the rich to be taxed more heavily 

than the poor, the economic and political power of rich taxpayers often allows them to 

prevent fiscal reforms that would increase their tax burdens. This explains in part why 

many developing countries have not fully exploited personal income and property taxes 

and why their tax systems rarely achieve satisfactory progressivity (in other words, 

where the rich pay proportionately more taxes). 

v. Developing countries attempting to become fully integrated in the world economy will 

probably need a higher tax level if they are to pursue a government role closer to that 

of industrial countries, which, on average, enjoy twice the tax revenue. Developing 

countries will need to reduce sharply their reliance on foreign trade taxes, without at 

the same time creating economic disincentives, especially in raising more revenue from 

personal income tax. To meet these challenges, policymakers in these countries will have 

to get their policy priorities right and have the political will to implement the necessary 

reforms. Tax administrations must be strengthened to accompany the needed policy 

changes. 

vi. As trade barriers come down and capital becomes more mobile, the formulation of 

sound tax policy poses significant challenges for developing countries. The need 

to replace foreign trade taxes with domestic taxes will be accompanied by growing 

concerns about profit diversion by foreign investors, which weak provisions against tax 

abuse in the tax laws as well as inadequate technical training of tax auditors in many 

developing countries are currently unable to deter. A concerted effort to eliminate these 

deficiencies is therefore of the utmost urgency. 

vii. Tax competition is another policy challenge in a world of liberalised capital movement. 

The effectiveness of tax incentives— in the absence of other necessary fundamentals 

— is highly questionable. A tax system that is riddled with such incentives will inevitably 

provide fertile grounds for rent-seeking activities. To allow their emerging markets to 

take proper root, developing countries would be well advised to refrain from reliance on 

poorly targeted tax incentives as the main vehicle for investment promotion. 

viii. Finally, personal income taxes have been contributing very little to total tax revenue 

in many developing countries. Apart from structural, policy, and administrative 

considerations, the ease with which income received by individuals can be invested 

abroad significantly contributes to this outcome. Taxing this income is therefore a 

daunting challenge for developing countries. This has been particularly problematic in 

several Latin American countries that have largely stopped taxing financial income to 

encourage financial capital to remain in the country. 

6.9 Criteria for the evaluation of a tax system 

Principles of an optimal tax system

The principles of an optimal tax system, what are known as Canons of taxation, some of which 

were laid down by Adam Smith include:

1. Simplicity

A tax system should be simple enough to enable a taxpayer to understand it and be able to 

compute his/her tax liability. A complex and difficult to understand tax system may produce a 

low yield as it may discourage the taxpayer's willingness to declare income. It may also create 

administrative difficulties leading to inefficiency. The simplest tax system is one with only a single 

tax. However, this may not be equitable as some people will not pay tax.

2. Certainty

The tax should be formulated so that taxpayers are certain of how much they have to pay and 

when. The tax should not be arbitrary. The government should have reasonable certainty about 

the attainment of the objective(s) of that tax, the yield and the extent to which it can be evaded. 

There should be readily available information if taxpayers need it.

Certainty is essential in tax planning. This involves appraising different business or investment 

opportunities on the basis of the possible tax implications. It is also important in designing 

remuneration packages. Employers seek to offer the most tax efficient remuneration packages 

which would not be possible if uncertainty exists.

3. Convenience

The method and frequency of payment should be convenient to the taxpayer e.g. PAYE. This may 

discourage tax evasion. For example, it may be difficult for many taxpayers to make a lumpsum 

payment of tax at the year-end. For such taxes, the evasion ratio is quite high.

4. Economic/administrative efficiency

A good tax system should be capable of being administered efficiently. The system should 

produce the highest possible yield at the lowest possible cost both to the tax authorities and the 

taxpayer.

The tax system should ensure that the greatest possible proportion of taxes collected accrue to 

the government as revenue.

5. Taxable capacity

This refers to the maximum tax which may be collected from a taxpayer without producing 

undesirable effects on him. A good tax system ensures that people pay taxes to the extent they 

can afford it. There are two aspects of taxable capacity.

a) Absolute taxable capacity

b) Relative taxable capacity

Absolute taxable capacity is measured in relation to the general economic conditions and 

individual position e.g. the region, or industry to which the taxpayer belongs.

If an individual, having regard to his circumstances and the prevailing economic conditions 

pays more tax than he should, his taxable capacity would have been exceeded in the absolute 

sense.

Relative taxable capacity is measured by comparing the absolute taxable capacities of different 

individuals or communities.

6. Neutrality

Neutrality is the measure of the extent to which a tax avoids distorting the workings of the market 

mechanism. It should produce the minimum substitution effects. The allocation of goods and 

services in a free market economy is achieved through the price mechanism. A neutral tax system 

should not affect the taxpayer's choice of goods or services to be consumed.

7. Productivity

A tax should be productive in the sense that it should bring in large revenue which should be 

adequate for the government. This does not mean overtaxing by the government. A single tax 

which brings in large revenues is better than many taxes that bring in little revenue. For example 

Value Added Tax was introduced since it would provide more revenue than Sales Tax.

8. Elasticity or buoyancy

By elasticity we mean that the government should be capable of varying (increasing or reducing) 

rates of taxation in step with the circumstances in the economy, e.g. if the government requires 

additional revenue, it should be able to increase the rates of taxation. Excise duty, for instance, 

is imposed on a number of commodities locally manufactured and their rates can be increased in 

order to raise more revenue. However, care must be taken not to charge increased rate of excise 

duty from year to year because they might exert inflational pressures on the economy.

9. Flexibility

It means that there should be no rigidity in taxation i.e. the tax system can be changed to meet 

the revenue requirement of the state; both the rate and structure of taxes should be capable 

of change or being changed to reflect the state’s requirements. Such that certain old taxes 

are discouraged while new ones are introduced. The entire tax structure should be capable of 

change.

10. Diversity

It means that there should be variety or diversity in taxation. That the tax base should be wide 

enough so as to raise adequate revenue and also the tax burden is evenly distributed among the 

taxpayers. A single tax or a few taxes may not meet revenue requirements of the state. There 

should be both direct and indirect taxes.

11. Equity

A good tax system should be based on the ability to pay. Equity is about how the burden of 

taxation is distributed. The tax system should be arranged so as to result in the minimum possible 

sacrifice. Through progressive taxation, those with high incomes pay a large amount of tax as 

well as a regular proportion of their income as tax.

Equity means people in similar circumstances should be given similar treatment (horizontal 

equity) and dissimilar treatment for people in dissimilar circumstances (vertical equity). 

There are three alternative principles that may be applied in the equitable distribution of the tax 

burden.

a. The benefit principle

b. The ability to pay principle

c. The cost of service principle

6.10 Tax reforms and modernisation of tax systems 

The Kenya Revenue Authority was established in 1995 as a semi-autonomous government 

agency responsible for revenue administration. The overall objective was to provide operational 

autonomy in revenue administration and enable its evolution into a modern, flexible and integrated 

revenue collection agency. 

Since the inception of KRA, revenue collection has continued to grow while professionalism in 

revenue administration has been enhanced. However, a number of processes remain manual 

and KRA is yet to operate as a fully integrated organisation. Thus the KRA Second Corporate 

Plan while acknowledging these challenges recommended appropriate strategies to address 

the same. This actuated the Revenue Administration Reform and Modernisation Programme 

(RARMP) which commenced in 2004/05 with the objective of transforming KRA into a modern, 

fully integrated and client-focused organisation.

The RARMP process has adopted project management and business analysis techniques in 

accordance with international best practice with the creation of the Programme Management 

and Business Analysis Office (PMBO) under the Office of the Commissioner General. This has 

led to the development of an institutionalised administrative framework for the RARMP making it 

easier to track progress in the reform initiatives and enhance project ownership and acceptance 

to change from both internal and external stakeholders.

The RARMP has now entered its Second Phase which will run until 2008/09 and will see the 

reforms entrenched at the operational levels to achieve operational efficiencies and enhance 

service delivery. This will be achieved through the implementation of the following seven key 

projects:

1. Customs Reforms & Modernisation Project

2. Domestic Taxes Reform & Modernisation Project

3. Road Transport Reform & Modernisation Project

4. Investigation & Enforcement Reform & Modernisation Project

5. KRA Infrastructure Development Project

6. KRA Business Automation Project

7. Human Resource Revitalisation Project

Achievements: 

Many positive developments in revenue administration were achieved during the implementation 

of the First Phase of the Revenue Administration Reform and Modernisation Programme. 

Overall, 

• Revenue collection has increased by 1% of the Gross Domestic Product from Kshs 

202 billion in 2002/03 to Kshs 297 billion in the 2005/06 financial year. 

• Income Tax, Value Added Tax and Domestic Excise were merged to form Domestic 

Taxes Department (DTD) while the mandate and taxpayer population of LTO was clearly 

defined with LTO being elevated to department status. 

• The Simba system was implemented to facilitate self-assessment and Post Clearance 

Audit (PCA) function was strengthened. 

• Support Service Department was created to consolidate support functions and enhance 

taxpayer services while the Office of Regional Heads was formed to bring services and 

decision making closer to taxpayers. 

• The KRA Information Communication & Technology (ICT) strategy was developed to 

act as the blue print for all future automation programmes. 

• Employee development programmes were undertaken and staff terms of service 

improved. 

Challenges:

Despite the achievements enumerated above, significant challenges still remain. These 

include:

• Lack of sufficient funding. 

• Implementation hiccups in Simba 2005 towards the attainment of a complete self 

assessment regime while faster progress is needed in the implementation of an 

Integrated Tax Management System. 

• Stakeholders’ resistance to reform initiatives. 

• Need for sustained efforts in fighting corruption and tax fraud. 

• Timeliness of legislative changes. 

• Human resource issues like remuneration, skills and integrity. 

The above challenges are recognised and adequately addressed in the Third Corporate Plan 

whose theme is ‘Develop a dedicated professional team embracing modern processes and 

technologies to deliver customer focused services that enhance compliance and revenue 

collection’.

Key perfomance indicators

Below are the Key Performance Indicators on the basis of which we not only will KRA evaluate 

itself but invite its stakeholders to evaluate it on the performance of the reform programme

• Improve tax compliance by 5% per annum (assuming an overall compliance level of 

60%). 

• Enhance revenue collection by an additional Kshs 15 billion per annum on account of 

improved compliance 

• Maintain cost of collection at below 2% of printed estimates. 

• Improved quality of service to stakeholders. 

• Improved public perception of KRA. 

• Competitive terms and conditions of service for employees. 

• Reduction in corruption/bribery index. 

• Number of KRA functions fully integrated. 

• Number of IT business solutions successfully implemented. 

• Quality and timeliness of production of statistics. 

Customs Services Department Reform and Modernisation Project (CRM) 

This project aims to transform Customs into a modern Customs administration by 2008/09 in 

accordance with internationally accepted conventional standards and best practice as outlined in 

WTO agreements and the WCO Revised Kyoto Convention on Simplification and Harmonisation 

of Customs Procedures. This will be done through: 

• Implementation of a fully function-based Customs structure and reengineering of 

Customs procedures from physically controlled checks to risk based and post release 

controls through strengthening of Post Clearance Audit. 

• Taking the lead in implementing an inter-agency review of border processing and 

clearance time to enhance service delivery at the borders. 

• Taking the lead at the regional level Customs in addressing deficiencies in the East 

African Management Act to streamline the import/export process. 

• Enhancement of the Simba 2005 system functionality in critical areas of manifest 

acquittal, management reporting and risk based selection. 

• Enhancement of staff competencies in critical areas such as risk-based approaches to 

cargo management and the adoption of post release verification and audit. 

Domestic Taxes Department Reform and Modernisation Project 

This project seeks to create a Domestic Taxes Department that is structured along the key tax 

administration functions of taxpayer education and services, returns and payments processing, 

audit, enforced collection and tax operations policy. This will be achieved through:

• Implementation of an Integrated Tax Management System (ITMS) that integrates both 

income tax and value added tax operations and takes a single view of the taxpayer. 

• Enhance service delivery by achieving complete taxpayer segmentation through 

building capacity in the Large Taxpayer Office and developing specific programmes 

targeting the Middle and Small taxpayers. 

Road Transport Department Reform and Modernisation Project 

Considerable progress has been made in automating RTD processes. This project aims at 

automating all remaining manual processes and simplifying administrative procedures through 

record keeping and file tracking features that support front office operations. The project also 

aims to achieve full connectivity of the RTD with all other KRA departments in order to ensure 

seamless flow of information. Indeed this is already being achieved through the interconnection 

between Simba 2005 system and the RTD system KOVIS.

Investigation & Enforcements Reform and Modernisation Project 

The project seeks to create a modern Business Intelligence unit that will analyse data to assess 

the risks inherent in transaction and ownership relationships which constitute the basis for 

evasion schemes. The project also seeks to strengthen the prosecution unit and implement a 

KRA-wide enforcement strategy to discourage tax malpractices by imposing maximum penalties 

and publicise recurrent evaders to deter future tax evasion. 

Infrastructure Development Reform and Modernisation Project

This project aims at ensuring that projects in the reform programme are given adequate support 

through timely acquisition and provision of needed utilities, upgrading of KRA infrastructure and 

enhancement of asset and security management systems. It also seeks to boost the capacity 

of KRA to respond to the various needs of stakeholders through the implementation of modern 

KRA-wide taxpayer education, integrity and accountability programmes

KRA Business Automation Project 

This project seeks to develop and implement an enterprise-wide IT strategy for KRA which 

promotes integration of domestic tax administration and the exchange of information between 

DTD, Customs and RTD. The project will enable a ‘single view of the taxpayer’ across all KRA 

functions, ensure efficient and effective revenue collection and attain operational excellence. The 

project will undertake to provide seamless sharing of information across KRA and interconnectivity 

with external systems of stakeholders to enable integrated e-processing of tax returns and 

efficient enforcement.

Human Resources Revitalisation Project

This project seeks to upgrade and diversify the skill base at KRA to international best practice 

standards with emphasis being placed on competency based management, recruitment and 

retention policy, establishment review and clearly defined career path progression.

For any reform programme to be successful, it needs to be hinged on a strong administrative 

structure that creates ownership and enhances ownership. KRA has put in place an elaborate 

governance structure for the RARMP.