Discussion Paper No. 179 of 2015 on A Fiscal Reaction Function for Kenya

Abstract

This study sought to determine whether Kenya’s fiscal policy is on a sustainable path by estimating a fiscal reaction function. A fiscal reaction function is a rule derived from an inter-temporal government budget constraint, which reveals the response of government to accumulating public debt. It also sought to establish whether fiscal policy responds to business cycles by determining its cyclical nature. The study used annual time series data spanning 1970 to 2013, and multivariate analysis based on VAR and VECM model. The empirical analysis reveals that, first, fiscal behaviour is incoherent with inter-temporal budget constraint, and the moderation is low. This implies that if fiscal adjustment is not done, debt is likely to accumulate. Second, expenditures during election cycles threaten Kenya’s long run fiscal sustainability. Finally, fiscal policy is a-cyclical, meaning that the stabilization objective is not considered when developing and implementing fiscal policy. The study recommends that comprehensive fiscal rules and regulations be enacted by an independent fiscal committee to correct these biases.