Kenya: Selected Issues and Statistical Appendix

This selected issues paper assesses Kenya's revenue performance, the labor market, and the health of the banking sector. It analyzes Kenya's revenue potential, tax system, and economic activity while increasing revenues; assesses the labor market; and also notes the nonperforming loans (NPLs) in the Kenyan banking sector, especially in public sector banks, and suggests structural measures to reduce cost pressures in the banking sector, lower the NPLs, and reduce the spread between lending and deposit interest rates. It also provides the detailed statistical appendix of Kenya.

Abstract

This selected issues paper assesses Kenya's revenue performance, the labor market, and the health of the banking sector. It analyzes Kenya's revenue potential, tax system, and economic activity while increasing revenues; assesses the labor market; and also notes the nonperforming loans (NPLs) in the Kenyan banking sector, especially in public sector banks, and suggests structural measures to reduce cost pressures in the banking sector, lower the NPLs, and reduce the spread between lending and deposit interest rates. It also provides the detailed statistical appendix of Kenya.

III. Labor Market Duality and Possible Reforms7

A. Introduction

16. Kenya’s labor market has undergone many changes in recent years, most notably a significant increase in informal sector employment. Although growth in informal employment has more than compensated for the stagnant or negative employment growth in the formal sector, it may have also led to a less sophisticated and low-skill production arrangements and thereby contributed to Kenya’s below-potential growth performance. Given the key role of the labor market for macroeconomic growth and development, removing impediments to the labor market’ efficient functioning is an important element of a macroeconomic reform agenda.

17. The remainder of this section proceeds as follows. Subsection B describes recent labor market developments in Kenya and their potential sources, and discusses some theoretical aspects of labor market duality. Subsection C briefly outlines some of the key elements of reform, and Subsection D concludes.

B. Kenya’s Dual Labor Market: Key Features, Determinants, and Recent Trends

Key features and determinants

18. As defined by the Kenyan authorities, the informal sector includes all semiorganized, small-scale, and unregulated activities. Some of the main features of informal sector production are the following: (i) firms and workers generally do not pay taxes;8 (ii) production is unregulated and therefore does not comply with minimum wage laws, safety procedures, and other regulations;9 and (iii) property rights are difficult to establish and enforce, resulting in limited access to financial markets.10

19. The lack of access to credit, in particular, constrains informal sector firms’ expansion possibilities. As a result, the informal production structure consists mainly of small-scale firms. The informal sector absorbs mostly low-skilled labor and is generally characterized as having low average productivity.11, 12

20. To understand the factors that determine the size of the informal sector of the labor market, it is helpful to view the growth in informal sector employment as the outcome of a rational decision-making process by workers and firms. Examining this process thus requires answering the question: what are the costs and benefits of creating or accepting jobs in the informal versus the formal sector?

21. A worker’s decision regarding where to seek employment will be determined by the availability of jobs in the formal versus the informal sector; the expected after-tax earnings differential, which necessitates the weighing of possibly higher wages in the formal sector against the tax burden and the costs of employment security; pension and other benefits; and workplace safety incurred in the formal sector. From the firms’ perspective, the main benefits of operating in the formal sector are better access to credit and financial markets and, partly as a result, the possibility of broadening the scale of production and increasing productivity, as well as operating within a regulated framework and thus avoiding fines. Costs of establishing formal production include the burden of taxes and licensing fees as well as compliance with administrative procedures and wage and job regulations.

22. A number of structural policies influence the size of the informal economy. These include minimum wages and other wage-setting institutions (such as the degree of unionization and the behavior of unions), taxation, and regulatory and administrative framework.

23. Minimum wages are generally positively related to the size of the informal sector and tend to make formal sector employment more attractive to workers. However, they also raise the costs of production for firms, thus providing an incentive to move production into the informal sector. Overall, a binding minimum wage leads to an excess supply of labor and reduced employment in the formal sector, implying a positive relationship between the level of the minimum wage and the size of the informal sector.13

24. High tax rates also contribute to a large informal sector. High taxes increase the costs of operating in the formal sector, while their weak enforcement in the informal sector reduces the costs of operating in that sector.14 Many countries respond to a shrinking tax base by increasing tax rates, thereby creating a vicious cycle of higher taxes and a smaller tax base. These considerations suggest the possibility of multiple equilibria; situations characterized by similar tax revenues, but with differing tax rates, informal employment shares, and tax bases.

Recent trends

25. The active labor force15 in Kenya can be divided into three segments: (i) the formal (or modern) sector, which includes wage employment in the private and public sectors, as well as self-employed and unpaid family workers; (ii) the informal sector, which includes all semiorganized, small-scale, and unregulated activities; and (iii) individuals engaged in small-scale agriculture and pastoral activities, as well as the unemployed. Individuals in the inactive population include full-time students, the infirm/incapacitated, the retired, and other individuals who report they do not need to work.

26. Time-series employment and wage data are available only for the formal and informal sectors from the Republic of Kenya Economic Surveys. Unemployment data and those on small-scale agriculture and pastoral activities are available only for 1998/99 from the ILS.16

Employment

27. Between 1981 and 2001, combined formal and informal sector employment increased at an average annual rate of about 7.3 percent, compared with an average annual growth of the population aged 15–64 of 3.7 percent. Most employment was created in the informal sector, which grew at an average rate of 12.2 percent over the same period, compared with average formal employment growth equal to 2.5 percent (see Table 4). The discrepancy between formal and informal sector employment growth has widened in recent years: formal employment grew by only 0.5 percent between 1997 and 2001, but shrank by 1 percent in 2001. On the other hand, average informal sector grew by 11.5 percent between 1997 and 2001, and 11.4 percent in 2001.17 The remainder of the active labor force, including employment in small-scale agricultural and pastoral activities and unemployment grew at an annual rate of 1.7 percent between 1980 and 2001, and at a rate of only 0.1 percent between 1997 and 2001 (see Table 4).18

Table 4.

Kenya: Labor Force by Sector, 1981–2001

(in thousands, unless otherwise indicated)

article image
Source: Kenyan authorities; and staff estimates.

28. Reflecting these developments, since 1994, the share of the informal sector in total employment has become larger than that of the formal sector, with the shares in the active labor force of formal, informal and small-scale agricultural/pastoral activities (including unemployment) changing from 17.2 percent, 6.6 percent, and 76.2 percent, respectively, in 1979, to 13.5 percent, 35.7 percent and 50.8 percent, respectively, in 2001 (see Figures 1 and 2).

Figure 1.
Figure 1.

Kenya: Sectoral Distribution of the Active Labor Force, 1979–2001

(in percent)

Citation: IMF Staff Country Reports 2003, 200; 10.5089/9781451821093.002.A003

Figure 2.
Figure 2.

Kenya: Employment Shares, 1984–2001

Citation: IMF Staff Country Reports 2003, 200; 10.5089/9781451821093.002.A003

29. The high growth rates for informal employment, combined with the small growth rates of the total labor force and stagnant or negative growth in other types of employment, suggest that the informal sector may have absorbed most of the new labor entrants. Also, some labor appears to have been rellocated from formal (and other types of employment) to informal employment.

30. Within the formal sector, public sector employment has decreased since 1997, while private sector employment has increased. The most notable change in industrial composition was an increase in the community, social, and personal services’ share to about 25 percent of total private sector employment in 2001 (see Figure 3), up from about 19 percent in 1984. Overall, however, compositional changes in the formal sector have remained fairly stable over the time period.

Figure 3.
Figure 3.

Kenya: Intrasectoral Employment Distributions, 2001

(In percent)

Citation: IMF Staff Country Reports 2003, 200; 10.5089/9781451821093.002.A003

Earnings

31. Wages in Kenya are determined within a three-tier system. Wages are set by the government through schemes of service and periodic salary reviews in the public sector, through collective bargaining for union members in the private sector, and by market forces for non-unionized workers in the private sector. The collective bargaining process involves tripartite arrangements between unions, employer representatives and the government. Most labor unions are affiliated with the Central Organization of Trade Unions (COTU), while the majority of employers are represented by the Federation of Kenya Employers (FKE). The resulting collective bargaining agreements typically include staggered long-term contracts, conditions of employment and fringe benefits.

32. The stagnant (recently negative) growth in formal employment has been accompanied by strong growth in average real wages per employee in the formal sector. Wages increased by 13.0 percent in 2001, and by an annual average of 12.3 percent between 1994 and 2001. Between mid-1980s and 1993, real wages fell, creating a U-shaped curve over the last two decades (see Figure 4). While informal employment has been increasing over the entire time period, its growth sharply accelerated around 1993–94, coinciding with the turnaround in real wages.19

Figure 4.
Figure 4.

Kenya: Sectoral Employment and Average Real Earnings, 1986–2001

Citation: IMF Staff Country Reports 2003, 200; 10.5089/9781451821093.002.A003

33. The large real wage increases are driven in part by similarly large increases in collective wage agreements and minimum wages. In 2001, the average bargained union wage increased by 15 percent in real terms, while minimum wages increased by 6.7 percent in real terms. Over the period 1994–2001, real collective wage agreements and real minimum wages grew at annual rates of 8.0 percent and 4.1 percent, respectively.

34. Average labor productivity, defined as real GDP divided by the size of the labor force, decreased between 1992 and 2001 at an average rate of -0.8 percent, and by -2.2 percent between 1996 and 2001 (see Figure 5). Consequently, since 1996, average minimum wage growth has exceeded average labor productivity growth by about 5.8 percentage points, while average real wages have grown about 11.3 percentage points faster than average labor productivity. Increased labor costs translate into increased costs of production and are likely to affect external competitiveness.

Figure 5.
Figure 5.

Kenya: Average Labor Productivity, 1982–2001

Citation: IMF Staff Country Reports 2003, 200; 10.5089/9781451821093.002.A003

35. Relative to average wages, minimum and union wages have, however, decreased in recent years (see Figures 6 and 7). This decrease has been less pronounced in the case of union wages, partly because of the limited, and decreasing, coverage of collective wage agreements.20 Interpreting these trends is a complex task because the direction of causality is difficult to determine. In particular, the data are consistent with two conflicting viewpoints. From one, these developments can be seen as reflecting a less restrictive impact of minimum wage laws on average wages, and thus suggesting that minimum wages have become less of a concern. Alternatively, the decreasing ratio of minimum to average wages can be interpreted as reflecting compositional changes in the formal sector’ earnings distribution that result from increasingly restrictive minimum wages. From this viewpoint, minimum wages have crowded the lower-income segments out of the formal sector into informal employment and unemployment, leaving more productive, higher-income employment in the formal sector; this suggests that existing minimum wage policies may have had a significant adverse impact on the labor market.

Figure 6.
Figure 6.

Kenya: Ratio of Urban-Area Minimum Wage1 to Formal Sector Average Wage, 1993–2001

Citation: IMF Staff Country Reports 2003, 200; 10.5089/9781451821093.002.A003

1 Excluding housing allowance.
Figure 7.
Figure 7.

Kenya: Ratio of Collective Wage Agreement to Formal Sector Average Wage, 1993–2001

(By industry)

Citation: IMF Staff Country Reports 2003, 200; 10.5089/9781451821093.002.A003

36. Interpreting the impact of tax developments is similarly difficult. Through their impact on disposable income and net profits, taxes are a potentially important determinant of the relative size of the formal sector. Although the top marginal tax rate has decreased in recent years, along with an increase in the top tax bracket, changes in the average tax incidence are difficult to gauge from such data. Figure 8 depicts total government revenues from direct income, profit, and capital gains taxes divided by formal employment as a proxy for the average tax incidence in the formal sector.21 According to this measure, tax incidence in nominal terms almost tripled between 1992 and 2001. By contrast, the average tax incidence as a fraction of average formal sector wages decreased slightly. Again, this development could be consistent with either a less or a more restrictive tax regime. In the latter interpretation, the observed decrease in tax incidence relative to wages is the result of compositional changes that resulted from an outflow of lower-income groups.

Figure 8.
Figure 8.

Kenya: Tax Incidence in the Formal Sector

Citation: IMF Staff Country Reports 2003, 200; 10.5089/9781451821093.002.A003

37. The latter view is supported by other aspects of the data. Figure 9 depicts the correlation of growth in the share of informal employment with growth in minimum wages, collective wage agreements (excluding housing allowance) and growth in total government tax revenues, all in real terms, over the period 1994–2001. Because the effects of changes in wage rigidities will permeate the economy slowly over time, the correlations are shown for different lags. Although the relationship is ambiguous in the case of collective wage agreements, mostly because of the low union coverage, the correlations do suggest that minimum wage and tax policies may have encouraged net labor flows into the informal sector. Both minimum wage and tax growth are highly positively correlated with the increase in the share of informal employment, both contemporaneously and lagged.22

Figure 9.
Figure 9.

Kenya: Correlation of Informal Employment Share Growth with Lagged Variables

Citation: IMF Staff Country Reports 2003, 200; 10.5089/9781451821093.002.A003

C. Macroeconomic Implications and Possible Reforms

38. Given the low average level of productivity of the informal sector, the rise in informal sector activity may have contributed to keeping Kenya’s economic growth below its potential. However, by circumventing the various rigidities and impediments in the formal sector, the informal sector has provided virtually all of the recent years’ employment creation in Kenya and has increasingly functioned as an avenue for creating economic activity that would not have been possible in the economic climate of the formal sector. Consequently, structural reform should be directed at correcting the incentives that forced economic activity into the informal sector, rather than at eliminating informal activities without providing viable alternatives in the formal sector.

39. Economic activity in the informal sector provides for a large future economic growth potential. For example, as seen in Figure 3, the categories of (i) manufacturing and (ii) wholesale and retail and restaurants and hotels are more strongly represented in the informal sector than in the formal sector. These industries are cited as among those with the highest future growth potential. Consequently, policies that allow these industries to operate in a climate conducive to higher productivity are also likely to significantly improve the Kenyan economy. Most notably, such policies include providing better access to credit in order to reduce financial constraints on the ability of firms to expand and adjust their production structure.

40. Reducing labor market rigidities, such as minimum wages, a nontransparent tax system, and other obstacles to operating in the formal sector, including administrative and regulatory costs, is likely to have significant potential for reducing the size of the informal sector and improving the overall efficiency of labor allocation. The potential benefits extend beyond raising average economic growth. Minimum wages, intended to protect the working poor and provide incomes for all labor market participants, particularly the unskilled, may, in an economy of weak growth, such as Kenya’s, contribute to a large flow of mostly unskilled and low-income worker groups into the informal sector or unemployment. Given the unregulated nature of the informal sector, precisely the worker groups for whose protection these laws were intended end up in low-paid, unregulated, and unstable employment relationships, with little potential for skill development. Relaxing minimum wage laws is, therefore, likely to both improve overall productivity and alleviate poverty through more productive employment creation in the formal sector.

41. Another key factor leading workers and firms to engage in informal sector activities is taxation. Taxes in Kenya are moderately higher than in comparable African countries; however, the tax system is characterized by a high degree of complexity and nontransparency. Tax revenues are also constrained by a small tax base, owing mainly to the large informal sector. Lowering personal and corporate income tax rates would likely increase the formal sector by reducing the costs of becoming formal. The impact on tax revenues is ambiguous but could well be positive, given the resulting larger tax base.23

D. Conclusions

42. The labor market in Kenya appears to be marked by labor market rigidities and wage distortions, which likely have hampered formal employment growth and resulted in the development of a large informal sector. The implications of these developments include an inefficient production structure, lost fiscal revenues, lowered growth prospects, reduced external competitiveness, and a deepening of poverty. Deregulation, particularly aimed at establishing a more flexible wage determination scheme, but also at easing income and other taxes, would help reverse many of these negative trends.

43. Although most of the above analyses and findings confirm the intuition of many observers of, and participants in, the Kenyan economy, including the authorities, the findings should, given the incomplete information on wages and production in the informal sector, be viewed more appropriately as posing, rather than answering, many of the questions of importance in developing a labor market strategy for Kenya. These questions should be answered more definitively within the context of more detailed future research.

References

  • Dessy, Sylvain, and Stéphane Pallage, 2003, “Taxes, Inequality and the Size of the Informal Sector,Journal of Development Economics, Vol. 70 (February), pp. 22533.

    • Search Google Scholar
    • Export Citation
  • Gatheru, Wamuyu, and Robert Shaw eds., 1998, Our Problems, Our Solutions: An Economic and Public Policy Agenda for Kenya (Nairobi: Institute of Economic Affairs).

    • Search Google Scholar
    • Export Citation
  • Ihrig, Jane, and Karine S. Moe, 2000, “The Influence of Government Policies on Informal Labor: Implications for Long-Run Growth,De Economist, Vol. 148 (September), pp. 33143.

    • Search Google Scholar
    • Export Citation
  • Maloney, William F., 2003, “Informality Revisited,World Bank Policy Research Working Paper No. 2965 (Washington: World Bank).

  • Olters, Jan-Peter, 2003, “The Informal Sector-Impeding Economic Development,” in Albania: Selected Issues and Statistical Appendix, IMF Staff Country Report No. 03/64, by Hossein Samiei and others (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Saavedra, Jaime, and Alberto Chong, 1999, “Structural Reform, Institutions and Earnings: Evidence from the Formal and Informal Sectors in Urban Peru,Journal of Development Studies, Vol. 35 (April), pp. 95116.

    • Search Google Scholar
    • Export Citation
7

Prepared by Martin Schindler.

8

This is mostly true for direct taxes. Informal sector activities are still subject to indirect taxes, such as VAT.

9

“Unregulated” production is to be distinguished from “illegal” production, which is not the focus of this section.

11

A recent strategy paper by the Kenyan authorities has pointed out that some small enterprises and microenterprises (SMEs) in the informal sector are, in fact, highly productive, paying higher wages than many formal-sector firms. While it is not surprising that the most productive informal sector firms surpass the least productive formal sector firms in terms of productivity, it is the differential in average productivities that is the cause of concern. Gatheru and Shaw (1998) also argue that the share of workers employed by SMEs is small. More important, even the more productive informal sector firms would likely benefit from the reforms outlined below. Finally, wages are only an imperfect measure of job quality. Jobs in the informal sector are often characterized by a lack of employment stability and health and other benefits. Consequently, even workers who find a high-wage job in the informal sector, relative to average formal sector wages, are not necessarily better off. (See also Maloney (2003)).

12

Although enterprises in the informal sector are generally said to have only limited access to credit, some informal businesses use “personal lines of credit” with financial institutions to finance their activities. However, the costs of these credit lines tend to be significantly higher than the costs of those available the typically larger, formal sector businesses.

13

A large informal sector may hide some of the aggregate impact of minimum wages as they are most strongly felt in the relatively small formal sector employment.

14

See Ihrig and Moe (2000) for empirical support and Olters (2003) for a discussion of some of these issues in the context of Albania. By contrast, Dessy and Pallage (2003) formulate a model in which the government uses taxes to produce public infrastructure that benefits formal sector agents more than those in the informal sector. In this environment, a lowering of tax rates does not necessarily lead to a reduction in the size of the informal sector because the associated reduction in public infrastructure expenditure also diminishes the benefits of formalizing.

15

As defined by the Kenyan authorities, the labor force includes all economically active individuals aged 15–64. According to the Integrated Labor Survey (ILS) 1998/99, about 22.6 percent of the total population aged 15–64 were economically inactive in 1999. Roughly two thirds of this group was accounted for by individuals aged 15–19, suggesting that schooling is an important reason for inactivity.

16

According to the ILS, the aggregate unemployment rate was 14.6 percent in 1999. However, interpretation of this number is made difficult because Kenya does not have an unemployment insurance system and its other types of social safety nets (the contributory social security scheme administered by the National Social Security Fund and the pension scheme administered by the Retirement Benefits Authority) are limited. In order to subsist, unemployed workers must therefore either live off their savings, engage in some type of unmeasured economic activity, or be supported by other types of social support systems (such as the family). In this environment, the distinction between concepts such as unpaid family workers, true unemployment, and underemployment becomes blurry.

17

By contrast, real GDP grew by an average annual rate of 2.9 percent between 1982 and 2001, and by only 1 percent between 1997 and 2001, suggesting that measured GDP growth may underestimate actual developments in aggregate production.

18

The active labor force is calculated assuming a constant share of the inactive population of 22.6 percent (from the 1998/99 ILS).

19

Over the period 1993–2001, real wages and the share of informal sector employment were almost perfectly positively correlated, with a correlation coefficient of 0.96 whereas the opposite was the case for real wages and formal sector employment, with a correlation coefficient of -0.97.

20

In 2001, only 43,031 employees were covered by collective wage agreements, down from 71,586 in 2000, and thus the aggregate impact of these wage increases was limited. However, collective wage agreements may have a much broader impact than these numbers suggest if spillover effects to nonunionized workers are important.

21

By the nature of the informal market, taxes are mostly collected in the formal sector.

22

Figure 9 suggests that minimum wages and taxes affect the labor market in different ways. Taxes seem to have a more immediate effect, with the correlation to informal sector employment decreasing as the number of lags increases, whereas minimum wages appear to have more lagged effects, with the correlation increasing along with the number of lags.

23

Employment in the informal sector was almost 2.7 times the size of formal sector employment in 2001. Even large reductions in average tax rates are therefore consistent with increased total tax revenues if they translate into a sufficiently large flow from informal to formal employment. Similar magnitudes are likely to hold for value-added tax (VAT) rates, licensing, and other fees.

Kenya: Selected Issues and Statistical Appendix
Author: International Monetary Fund
  • View in gallery

    Kenya: Sectoral Distribution of the Active Labor Force, 1979–2001

    (in percent)

  • View in gallery

    Kenya: Employment Shares, 1984–2001

  • View in gallery

    Kenya: Intrasectoral Employment Distributions, 2001

    (In percent)

  • View in gallery

    Kenya: Sectoral Employment and Average Real Earnings, 1986–2001

  • View in gallery

    Kenya: Average Labor Productivity, 1982–2001

  • View in gallery

    Kenya: Ratio of Urban-Area Minimum Wage1 to Formal Sector Average Wage, 1993–2001

  • View in gallery

    Kenya: Ratio of Collective Wage Agreement to Formal Sector Average Wage, 1993–2001

    (By industry)

  • View in gallery

    Kenya: Tax Incidence in the Formal Sector

  • View in gallery

    Kenya: Correlation of Informal Employment Share Growth with Lagged Variables