Kenyan Protests, Part Two: How not to clean up a fiscal mess

Generalized erosion of fiscal pact and trust in government raise the specter of widespread tax evasion, proliferation of informality, and unmanageable deficits

This is the second of a three part series on the current economic and political crises in Kenya. Part One addresses the political foundations of the crisis. Part Two will tackle the real economic challenges that the current administration inherited, and arguably made worse. Finally, Part Three will conclude with some thoughts on the set of bad options on the table for the administration.

I: The making of a fiscal mess

On July 11, 2024 President William Ruto dissolved his Cabinet following weeks of protests against his administration. As discussed in the previous post, the immediate trigger of the countrywide popular revolt was a raft of tax increases in the 2024 Finance Bill. But the grievances were deeper. Ruto came into office with a legitimacy deficit that has proven difficult to shake off. His Cabinet was one of the weakest in Kenya’s history and had come to symbolize the out-of-touch incompetence and arrogance towards the public associated with the administration. Real incomes were in decline, squeezed by a stagnating economy, inflation, and higher taxes. And the quality of public services (especially in education and health) had deteriorated for years even before Ruto came into office.

The expected changes in the Cabinet might buy Ruto political breathing room — especially if he appoints a competent set of Cabinet Secretaries. However, it is unclear if he will choose the path of competence and effective service delivery. So far all indications are that he will go for a “unity government” that brings in individuals from across the political divide and consolidates intra-elite collusion in opposition to the structural reforms demanded by protesters.

Such a move will only fuel popular anger at the entire political class and likely result in more protests.

The fundamental problem for Ruto is that he faces a very difficult fiscal crisis (see image below) at a time when the old playbook of Kenyan politics doesn’t work anymore. People want effective service delivery and a working economy. To be blunt, you cannot deliver on either of those objectives by merely crafting an ethnically representative Cabinet.

Kenya’s decade-long lumpy “refinancing wall” as described by David Ndii, President Ruto’s chief economic advisor. Source: Bloomberg

Let’s be clear, Kenya’s current fiscal crisis is bigger than Ruto and reflects the challenges of executing infrastructure-led development without paying deliberate attention to broad-based job creation and effective delivery of public services. Especially under President Uhuru Kenyatta (2013-2022), Kenya’s debt accumulation outpaced the rate of revenue growth because the government borrowed money for recurrent expenditures and (graft-laden) infrastructure projects that didn’t yield the projected household-level economic impacts. The economy expanded, but the benefits mostly accrued to the very top earners and politically-connected firms that got tax exemptions. Meanwhile, the quality of public services deteriorated and informality continued to dominate the private sector.

The entire Kenyan economy ($113b) supports barely 3 million wage jobs. An astonishing 67% of Kenyans under 34 lack stable jobs. The “Kenyatta economy” expanded by over $50b but without much improvement in the annual rate of wage job creation.

Trends in the year-on-year growth rate of the total number of wage jobs in the public and private sectors. Source: Author using data from KNBS

Furthermore, there is actually very little to show for the Kenyatta era debt binge. To paraphrase The Economist, Kenyatta mostly started projects to get loans, and not the other way round. Besides the SGR — which without reaching Uganda and beyond will remain commercially unviable — gross capital accumulation as a share of GDP peaked in 2014 and declined thereafter. The infrastructure boom under President Mwai Kibaki (2003-2013) was followed by a period of corruption-fueled dealmaking that paid scant attention to projects’ commercial viability or their economic impact. Kenyatta inherited a debt stock of about $22b and added a staggering $51b to it. When he left office, there were still more than 400 stalled projects that had cumulatively gobbled up billions of shillings.

The rate of gross fixed capital accumulation as a share of output declined during Kenyatta’s tenure. Source: Author using World Bank data

President Kibaki started the infrastructure boom. However, the massive spending on infrastructure was accompanied by broad-based economic growth and an increase in revenue collection. Therefore, even as deficits rose, the proportion of revenues that went to debt service and the Debt/GDP ratio remained fairly flat (see below).

Kenyatta upended this model in two important ways. First, he relaxed tax administration by awarding all manner of exemptions to cronies and being quick to buy political support with subsidies. Tax expenditures (roughly, taxes foregone due to exemptions) as a proportion of GDP soared to just under 3%, and the overall tax/GDP ratio reduced from 18% to under 14%. Second, he increased the share of foreign borrowing from commercial lenders to about a third of total foreign debt. Unlike multilaterals and bilaterals, these commercial lenders came with no strings attached, much higher interest rates, and their loans were often used to roll over debt and not tied to specific projects (which facilitated pilfering). Increases in debt as a share of GDP, the share of revenues allocated to debt servicing, and bigger deficits followed.

Attempts to plug holes with increased domestic borrowing crowded out credit to the private sector, putting a limit on private sector growth. Domestic credit to the private sector (as a % of GDP) steadily fell from its peak in 2015.

Trends in deficit spending and debt burden in Kenya. Source: Author using data from KNBS

Kenyatta also failed to craft a coherent industrial policy to back up his infrastructure spending. Here, the examples of Chinese-financed projects are instructive — as neatly summarized by David Ndii (currently Ruto’s chief economic adviser):

Moreover, the government shoots itself in the foot by awarding the construction projects to foreign— predominantly Chinese—state-owned firms. This undermines revenue in two ways. First, the companies are exempted from paying tax. Second, the money they make is repatriated, denying the economy the multiplier effect it would have if the money had been earned by domestic firms.

… [Kenyatta] went and swiped the national credit card and the Chinese delivered the goods. The money stayed in China, debited from our loan accounts in the Chinese banks and credited to the suppliers’ bank accounts. We are paying the loans from our pockets. This year, we’ve budgeted to pay the Chinese banks Sh94 billion, up from Sh39 billion last year. Far from circulating it in the economy, foreign debt-financed government projects are draining money from the economy.

Overall, Kenyatta lacked a coherent economic agenda throughout his tenure. This meant that he did not adequately respond to the end of the global commodity supercycle in 2014, thereby occasioning bigger trade deficits, the shilling’s weakening, and the beginning of a balance of payment problem. The “Big Four Agenda” (agriculture, housing, manufacturing, and healthcare) was more of a PR exercise than a coherent plan. It is not surprising that when COVID and the inflationary aftermath hit, the economy almost went into a ditch.

How did Kenyatta get away with all of this? On the electoral front, negative political ethnicity helped. As long as ethnicity was the dominant organizing principle in politics he could herd voters into ethnic pens, find non co-ethnic scapegoats (especially Raila Odinga), and get away with ruinous economic mismanagement. Protests did happen, but the administration successfully cast them in ethnic terms and proceeded to brutally repress them. In terms of policy, the business community was too fragmented to coordinate their lobbying. Traders benefitted from the import-crazed consumption economy. Manufacturers could individually lobby for tax exemptions (though many still struggled). Banks benefitted from government borrowing. SMEs were the only sector that was almost uniformly thrown under the bus.

Eventually, things got so bad that Kenyatta’s own co-ethnics in the SME sector rebelled against his administration and bought into Ruto’s message of “bottom up” economic populism.

It is this mess that Ruto inherited upon assuming office in 2022. Yet instead of honestly confronting the issues, he wanted to have his cake and eat it. Which brings us to the role of the International Monetary Fund (IMF) program in the current crisis.

II: How not to clean up a complicated fiscal mess

Kenya’s IMF program — designed to stabilize the currency, reduce deficits, increase revenues, all while avoiding cuts on essential public goods and services — illustrates the limits of relying on “apolitical” technical support in policymaking. In practice, the IMF’s fiscal consolidation program has so far progressed as if Kenya’s current crisis was merely an accounting problem, rather than an intricate political economy problem. This is, in fact, the message that the protesters refuse to let Ruto ignore.

Over the last two years the Kenyan government has principally focused on revenue-driven fiscal consolidation. This is partially because the Fund had little (political) leverage or ability to influence the rationalization of expenditures or improvements in service delivery — which are critical for buying political support and strengthening the fiscal pact in exchange for painful tax hikes.

The IMF also had an information problem. From their perspective, Kenyan authorities’ stated political limits of taxation were always going to be lower than what obtained in reality (and impossible to discern). Therefore, the Fund very likely assumed that Kenyan leaders preferred to avoid politically unpopular revenue reforms if they could. So they pushed hard on fiscal consolidation on the revenue side to reinforce the government’s approach that sought to raise the revenue/GDP ratio from 14.1% to 25% in the medium term.

Other targets related to SOE reforms, climate, illicit finance, cushioning low-income households against inflation and higher taxes, and reducing corruption seemed to be mere bells and whistles designed to get board approval at the Fund — and were rationally deemphasized by the Ruto administration.

Incentives matter. The IMF had a narrow primary goal of fiscal consolidation and not the promotion of growth and/or improved service delivery. In other words, they were firefighters with a very narrow objective and not architects that could help Kenya chart a new path towards sustained rapid economic growth and development. Therefore, even as the Fund lent the government credibility in credit markets and elongated Ruto’s domestic political runway with cash disbursements and related appreciation of the shilling (and reduced inflation pressures), the Fund could not stop the Kenyan government from distributing fake fertilizer to farmers, wasting billions in abandoned industrial parks, poorly implementing programs like the “Hustler Fund” or the housing scheme, or generally presiding over the deterioration of public services.

Inexplicably, Kenyan authorities trusted that the IMF program would work despite the political risks involved. Simply put, Ruto wanted to have his cake and eat it. He knew full well the crisis he had inherited from Kenyatta. Yet his main focus was raising revenues to keep the IMF cash flowing and gain credibility in international debt markets, while doing precious little to boost broad-based growth, rationalize expenditures, cut waste, reduce corruption, and improve service delivery as part of a political fiscal pact with Kenyans. Ruto justified the one-sided reform as necessary to avoid economically inefficient austerity measures — an argument that fit neatly with the IMF’s newfound fear of being branded as agents of heartless austerity.

This two-sided miscalculation by the IMF and the Kenyan government led to the aggressive revenue targets that have now backfired spectacularly and pushed Ruto into a corner.

It is tragic that it took widespread protests (and an unconscionable death toll of at least 41) for Ruto to accept reality. While firing his Cabinet on July 11th, he noted the need for a “broad-based government” charged with:

accelerating and expediting the necessary, urgent and irreversible, implementation of radical programmes to deal with the burden of debt, raising domestic resources, expanding job opportunities, eliminate wastage and unnecessary duplication of a multiplicity of government agencies and slay the dragon of corruption consequently making the government lean, inexpensive, effective and efficient.

Given what he and his economic team knew coming in, where was the urgency over the last 18 months? And why weren’t these reforms already being seriously implemented under the IMF program?

III: Some concluding thoughts

How does the Ruto administration begin an honest clean up of Kenya’s fiscal mess? In my view, the first and most important challenge will be restoring public trust and tax morale. Second, the administration needs a coherent growth agenda. Even if backed by credibility procured from the IMF and the World Bank, playing accounting games with revenues and debt rollovers, while ignoring a genuine commitment to growth and mass job creation in the formal sector, will not cut it. Kenya must grow in order to expand the revenue base and provide relief to households squeezed by years of declining real incomes.

This is why I will be keen to see who the president appoints to lead the key portfolios at Treasury, Agriculture, Trade & Industry, Infrastructure, and the service ministries of Education and Health. Appointments in these dockets will signal whether Ruto is interested in buying legitimacy through a coherent pro-growth and pro-jobs agenda (with attention to human capital development, improved agricultural productivity, manufacturing, and increasing exports), or through the usual games of intra-elite collusion and suppression of vertical accountability.

It is worth reiterating the importance of restoring public trust and tax morale. Kenya’s decade-long fiscal wall shown above and heightened demand for high-quality service delivery will require more revenue. Cutting spending on Parliament (<1% of the budget), the Judiciary (even smaller), reducing corruption (elimination is impossible), or even cutting away clear wastage in public agencies will only go so far. If voters don’t want cuts on essential public goods and services, the ratio of revenues to output must rise to at least the pre-Kenyatta levels (18%).

Here, as I highlighted in a recent Bloomberg column, the government faces two related challenges. First, Kenya’s fiscal pact is broken, with the public unwilling to countenance any tax increases without appreciable improvements in service delivery. There is also little appetite for cuts in government spending. In the interim, movement in either the revenue or expenditure side will likely dampen tax morale further and reduce the government’s revenue haul.

Second, tax administration capacity still lags the government’s revenue plans. In the moribund 2024 Finance Bill, the government had promised a rosy 16.4% increase in revenues. Forget that in the previous 5 years the Kenya Revenue Authority (KRA) had never cracked a 6.5% increase in year-on-year revenue. The KRA’s main challenge stems from the fact that the so-called informal sector — which is relatively illegible to the state — continues to dominate the Kenyan economy. As such, it is hard to levy direct (income) taxes whether targeting firms or individuals. The government has therefore been forced to rely on aggressive (and often regressive) indirect taxes (like turnover and consumption taxes) that are increasingly seen as counterproductive. In a number of instances new taxes have resulted in declining revenues.

Relatedly, the government’s habit of scouring the economy for new sources of revenue every few months has introduced systemic uncertainty over tax policy. If tax policy uncertainty persists, it will undoubtedly depress private investments and reduce government revenues in the long run.

The government needs more revenue. But to get there it must first demonstrate fidelity to the fiscal pact.

I would like to conclude by noting that the Kenyan economy is not going to hell in a hand basket. Now is not the time to wallow in unhinged catastrophizing. Nominal growth in 2024 is projected to reach 5.5%. In addition, the country’s institutions are strong enough to absorb and appropriately channel ongoing expressions of public discontent. In my view, if President Ruto can rise to the occasion, the protests present an opportunity to iron out the many contradictions that characterize Kenya’s political economy. If the 2010 constitution settled the political questions over self-government and distributional access to the “national cake,” the current protests have began a process of cementing a new fiscal pact built on a foundation of sound economic management and political accountability. That is a good thing.