INVESTIGATING THE RELATIONSHIP BETWEEN GOVERNMENT EXPENDITURE AND TAXATION: EMPIRICAL EVIDENCE FROM KENYA

Abstract

The principle objective of the study was to establish the nexus between government expenditure and taxation and find out the relationship that exists between the two variables for the case of Kenya. Using empirical evidence, the study focused on establishing the causal flow between government expenditure and taxation and the long-run relationship between the two variables in a manner to gauge the sustainability of the fiscal policy regime in place. The study uses time series annual secondary data covering the period 1980 to 2012 and data analysis was done using E-views 7 software. To determine the causal relationship, Granger causality tests were conducted within the Vector Error Correction Modelling (VECM) environment. The statistical techniques used include the Augmented Dickey Fuller (ADF) test to check for stationarity of all the time series variables in their first differences i.e. I (1). The Johansen-Jesulius Maximum Likelihood Method of Co integration was employed to establish whether the variables are cointegrated by interpreting the Trace statistics and the Maximum Eigen-value output. The results show stationary at first difference and cointegrated with one co-integrating vector. Granger causality tests conducted to establish the nature and direction of the causality within the estimated model indicated the presence of unidirectional long-run causal flow running from government expenditure to tax revenues and a bi-directional short-run relationship between government expenditure and tax revenue implying a two way causal flow such that changes or alterations on either variable causes an instantaneous reaction on the other. The long run uni-directional finding gives credence to the spend – and – tax hypothesis suggesting a government system that determines how much to spend and then later design the tax measures and policy actions to finance that level of spending. It is, therefore, imperative for the government to pursue expenditure-targeting reforms with proper costing framework for all outlays while improving tax collection and utilization to mitigate effects of fiscal imbalance to achieve sustainable levels of aggregate spending and expenditure. Keywords: