Discussion Paper No. 82 of 2007 on Estimating the Size of the Underground Economy in Kenya

Abstract

The underground economy comprises economic activities not accounted for in national income statistics and is, therefore, difficult to measure. The difficulty arises because this economy comprises a host of traditional and modern; monetary and non-monetary; and legal and illegal activities. Some are invisible, hidden and illegal. Others are visible but difficult to trace, locate or identify because they are mobile and/or lack proper records. Measurement problems are also compounded by its continued evolution, adapting to changes in the policy and technology environments. However, knowledge of its size is important for policy relevance and revision; avoiding threat to revenue generation; easing tax burden on the formal sector; encouraging fair competition; exercising control for illegal activities; and expanding the tax base. Direct and indirect approaches have been used elsewhere to estimate its size. Direct approaches include: sample survey and tax audit/compliance, and indirect approaches comprise national accounting statistics, labour force statistics, transactions, currency demand, physical inputs such as electricity, and multiple indicators multiple causes (MIMIC) models. Using the currency demand model, which assumes that most transactions are undertaken on cash basis, and secondary data between 1970 and 2005, the study found that the size of the underground economy in Kenya is significant. It averaged 20 per cent of GDP between 1995 and 2005. Besides, tapping it could expand tax base by about 4 per cent of GDP. In 2005, this would have generated nearly Ksh 55 billion. The study recommends greater innovations such as use of debit and credit cards and ATMs; improvement in data capture; continuation of reform efforts such as use of presumptive tax; reduction in bureaucracy in business licensing; recognize tax contributions by awarding certificates; and further work to isolate legitimate and illegitimate activities to inform reform efforts.