The Effect of foreign direct investment on tax revenue in Kenya
Nasibu, Sharon Makena
Raising adequate domestic revenue is a challenge particularly for low and middle-income countries with low domestic savings rates. Domestic revenue shortfalls have persisted in Kenya for the last several years and in this time, public debt has ballooned and borders on unsustainability. Globalization and increased capital mobility have created pressure for governments to provide tax incentives in order to attract and retain foreign direct investment. Consequently, a “race to the bottom” has ensued in which foreign investors benefit from these tax incentives, at the expense of governments which lose much needed revenue particularly in developing countries. This study sought to determine the effects of FDI on aggregate and disaggregate tax revenue in Kenya, as well as the moderating effect of GDP per capita and trade openness on the association between FDI and tax revenue. The study was based on the theory of public fiscal behaviour and theories of tax competition. A descriptive correlational research design was adopted with the unit of analysis being Kenya. Secondary time series data was collected from relevant databases including KNBS, UNCTAD, The World Bank, and IMF. In relation to the first study objective, the findings showed that FDI stock had a negative effect on aggregate tax revenue in the short run and FDI inflows had no effect. In the long run, FDI stock did not have any effect on aggregate tax revenue but FDI inflows had a negative effect on aggregate tax revenue. Regarding the second objective, FDI stock had a positive effect on disaggregate tax revenues in the short run but no effects were observed in the long run. On the other hand, no interaction was observed between FDI inflows and disaggregate tax revenues. The third objective was to determine moderating effects of macro-economic variables (trade openness and GDP per capita) on the relationship between FDI and tax revenue. Results from hierarchical regression models revealed that trade openness and GDP per capita had a positive but insignificant effect on the relationship between FDI and tax revenue. The study concludes that FDI stock has a negative effect on aggregate tax revenues in the short run but no effect in the long run. Moreover, it is the study’s conclusion that FDI inflows have no effect on aggregate tax revenue in the short run but they have a negative effect in the long run. The study concludes that an increase in FDI stock increases disaggregated tax revenue indices while no effects are observed in the long run. The study further concludes that FDI inflows have a negative effect on disaggregated tax revenue indices in the long run, however this is not statistically significant. Furthermore, GDP per capita and trade openness do not exhibit moderating effects on the relationship between tax revenue and FDI. Among the key policy implications from this study, it is recommended that tax incentives be reduced but not completely eliminated, so as to attract and retain foreign investment while safeguarding revenue collection efforts. Gradually scaling back tax incentives while promoting other measures of attracting FDI is proposed, including but not limited to; enhancing infrastructure and technology, enhancing access to domestic markets, strengthening supply value chains and setting up investment promotion agencies to target and link foreign investors and the domestic economy. Policy makers should also focus on designing economic policies that encourage retention of existing FDI stock.
A dissertation submitted to Strathmore Business School in Partial fulfillment of the requirements for the award of Master of Science in Development Finance Degree of Strathmore University