The informal taxation system in Kenya is widespread and regressive. It responds to changes in permanent income, rather than temporary income, suggesting that permanent income increases are important for public goods provision.
A central question in development economics is how to fund public goods such as water resources, roads, and schools. The standard mechanism of doing so is through the formal taxation system. However, informal taxation, whereby households make direct contributions to local public goods outside of the formal tax system, is an important source of funding for public goods in many developing countries, especially Kenya (Olken and Singhal 2011, Ngau 1987, Barkan and Holmquist 1986). Informal taxes are coordinated and collected by local community leaders and enforced via social sanctions rather than the state. The relationship between informal taxes and household income is not clearly defined as in formal taxation systems. This leads to an interesting question: how does informal taxation affect inequality and welfare?
While a large literature finds positive benefits from cash transfers for recipient households (Bastagli et al. 2016, Banerjee et al. 2016, Evans and Popova 2017), less attention has been paid to how these programmes interact with local public finance, especially as the scale of these programmes continues to increase. If one-time cash transfers to poor households can lead to an increase in public goods investment, this provides a mechanism for long-term and spillover benefits to non-recipients.
My study is based in rural Kenya, where local leaders collect informal taxes via community fundraisers (known as harambees), village meetings, and by going door-to-door. Payments are made primarily in cash. Other forms of payment include labour and in-kind contributions. Households that do not pay are subject to social sanctions such as public announcements, letters, and home visits (Miguel and Gugerty 2005).
My research quantifies informal taxation in Kenya. Using household data:
- I estimate informal tax schedules over the income distribution and test whether informal taxes respond to changes in earned income.
- I estimate how informal taxation and public goods respond to a large, one-time increase in income from a randomised unconditional cash transfer programme targeting poor households.
Informal taxation is widespread, redistributive, and regressive
I find that informal taxation is widespread, with over 40% of households participating in the last 12 months, twice the participation rate for formal taxes. I also find that informal taxes respond to changes in earned income: a one decile shift up the earned income distribution is associated with an increase of approximately 10% of the mean informal tax amount. This suggests that leaders are aware of household income changes, and are able (and willing) to change tax payments in response to changes in household income. However, both informal tax participation, and the amount paid are increasing in household income but declining as a share of household income, implying informal taxes are regressive. In fact, I find informal taxes are more regressive than formal taxes.
One-time cash transfers and informal tax
The NGO GiveDirectly provided a large, one-time unconditional cash transfers amounting to poor households in 653 villages in rural western Kenya meeting a basic means-test. These households received a series of three payments over eight months totalling almost $1,000 (nominal) via the mobile money system M-Pesa.
No effects on informal taxes or public goods
I analysed the impact of this programme on informal taxation and public goods. I find no significant effect on informal tax amounts and participation for cash transfer treatment households, nor ineligible households in treatment villages. The $0.14 for cash transfer treatment households i.e. households that received a cash transfer is 0.01% of the total transfer value, and significantly less than the predicted change of $1.66 if transfer income was taxed the same as earned income for control households.
Given the informal tax results, it is unsurprising that I find no increase in the number of village public goods projects, both overall and for water resources, for which informal taxation is especially important. Notably, while the cash transfers do not appear to increase public goods, they do not have a negative effect.
Local leaders exempt the cash transfer from informal taxation
I found the above result on informal taxes surprising, given that i) leaders are aware of transfers and ii) informal taxes respond to changes in earned income. This result holds across every level of income. This suggests that local leaders are exempting the transfer income from informal taxes. Taken together with the fact informal taxation responds to changes in earned income for control households, this provides suggestive evidence that informal taxation responds to permanent, rather than temporary, changes in income.
Alternatively, leaders may exempt the cash transfer to allow households to make productive investments now in return for larger payments in the future. However, I find no heterogeneity in effects on informal taxes by the number of months since transfers began, though these are all relatively short-run effects (less than two years). I also do not find that leaders extract larger contributions for community fundraisers for social insurance, such as funerals and weddings, nor for bribe payments, from cash transfer treatment households
I do find some evidence of “kinship taxation” (Jakiela and Ozier 2016, Squires 2017) - cash transfer treatment households send about 25% more in inter-household transfers, predominately to other family members, compared to eligible households in the villages who do not receive the cash transfer. The magnitude of this increase, however, is still less than 1% of the cash transfer value.
Implications of results
My findings first show that in rural Kenya, informal taxation is more widespread and regressive than formal taxation. Despite this, local leaders do not overtax poor households that receive an unconditional cash transfer. However, I find no increase in public good investment, tempering possible spillover or long-term benefits from one-time cash transfers. Importantly, I do not find negative effects on public good provision, and these findings do not negate the positive benefits to recipient households documented in the literature. To the extent informal taxation is based on permanent rather than temporary income, changes in permanent income are required in order to increase public goods provision via informal taxation.
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Squires, M (2017), “Kinship taxation as an impediment to growth: Experimental evidence from Kenyan microenterprises” Working paper.