Discussion Paper No. 240 of 2020 on Assessing the Sustainability of Fiscal Policy in Kenya

Abstract

Fiscal policy sustainability is key for medium to long-term growth of any economy. Maintaining fiscal sustainability helps create enough fiscal space to mitigate economic shocks. Over the years, fiscal space in Kenya has been constrained by rising Government expenditures with persistent development needs. This has led to the widening of the fiscal deficit despite instituted austerity measures and tax reforms introduced to enhance revenue collection. In addition, the country has not been able to meet its fiscal deficit targets over the years. As a result, concerns arise on the status of fiscal policy sustainability in Kenya, which has motivated this study. The study employed the Johansen cointegration technique followed by the two-step Engle-Granger approach to assess sustainability of fiscal policy in Kenya. Empirical findings indicate that fiscal policy in Kenya is weakly sustainable. That said, the economy adjusts fast in instances of disequilibrium caused by various shocks. To ensure fiscal sustainability is maintained in the long run, the study recommends putting in place a fiscal consolidation plan with a mix of expenditure and revenue measures. Specifically, the Government could focus on reducing the share of salaries and wages, which is the largest component in the recurrent expenditures. Similarly, retiring short-term and expensive commercial debt by increasing the share of concessional loans in financing fiscal deficit will serve to reduce interest rate obligation. To increase tax revenues, the study recommends a review of the multiple exemptions, including those on VAT and other incentive schemes such as deductibles and investment allowances under corporate tax.