Sarah Wangari Karega

 Background of the study Background of the Study Small and Medium Enterprises are an essential element in the economic growth and development of every nation (Atawodi & Ojeka, 2015). The micro enterprises contribute significantly to the creation of employment opportunities and growth of the economy. SMEs are private enterprises and are faced with a myriad of challenges when dealing with government tax administration especially in the developing countries. The performance of SMEs is considered a significant element of the economy since such entities are the backbone of the economy (Al Asheq & Hossain, 2019). Entrepreneurship that thrives in the SMEs is the main engine of economic growth in Europe. Good performance of SMEs in 2015 within Europe led to 3.9 trillion Euros being generated by only 23 million enterprises (European Commission, 2017). Moreover, the SMEs in Romania generated 50% of the value added to the economy in the year 2015. SMEs play a key role in the reduction of unemployment within Europe and other decentralized economies globally. The SMEs performance in Europe and the Americas was robust and quick to recover following the 2008 financial crisis that shook the global economy (Jerkovic, 2017). The versatility and ability to adapt to challenges within the SMEs ensures that such entities are strong in the long-term and able to overcome the challenges of a financial meltdown. The actions and policies undertaken by government in terms of business development are crucial to performance of the SMEs in Malaysia and Asia-Pacific region (Isaga, 2018). The tax regime is cited as a significant factor that determines the financial performance of the SME entities that thrive in Malaysia. Similarly, Isaga (2018) asserts that the innovation policy within the United Kingdom has a significant impact of the performance of SMEs within the manufacturing sector. Innovation drives the productivity and resilience of SMEs. Moreover, organization performance correlates with the SME performance within the nation and the network the entrepreneur has in the industry (Mohammed & Hicham, 2018). Subsequently, the performance of the SMEs relies heavily on multiple variables both externally and internally. The entrepreneur can work towards improving the internal factors such innovation capability and the marketing aspects but external factors such as taxation and government policy are beyond the scope of the entrepreneur. Consequently, there is a consistent pattern of SMEs performance depending on the government policies and regulations. SMEs occupy the largest portion of all businesses in Africa and represent 90% of all Business entities within South Africa where they contribute 50% of the nation’s GDP (Ngek, 2018). Unfortunately, the performance of most SMEs faces significant Challenges that lead to 50-95% of the businesses failing within the first five years. Moreover, the emphasis has been on internal factors that limit growth of the SMEs but External challenges have not been explored comprehensively (Everest-Phillip & Sandall, 2019). Some of the limitations to SME performance include customer relationship that Can reduce the amount of products sold on a regular basis. The characteristics of Entrepreneurs determine the interaction of the business with other stakeholders including Government officers and this leads to a predetermined level of efficiency and Profitability. Isaga (2018) research states that the performance of SMEs in Tanzania is Directly correlated with the personal traits of the entrepreneur in the particular industry. The profitability of the SME determines whether the business has enough funds to Undertake operations in the following years. Muturi (2016) asserts that SMEs performance in Kenya is affected by the capital held by Entrepreneur and the resources available to the business. SMEs in Kenya rely on banks For capital financing or some use retained earnings from previous profits made by the Business. Unfortunately, the performance of SMEs lags behind the multinationals and Big corporations that can pool resources easily under short timelines (Erard, 2017). Developing nations such as Kenya have clear understanding on the importance of SME Performance in fueling the growth of the economy. SMEs contribute at least 98% of the national GDP and 50% of the workforce (Dinis, Martins & Lopes, 2017). Subsequently, The profitability of such enterprises is significant to the government and the tax Administrators since they rely on positive performance and cash flow availability in the SMEs in Limuru Sub – County. national GDP and 50% of the workforce (Dinis, Martins & Lopes, 2017). Subsequently, the profitability of such enterprises is significant to the government and the tax administrators since they rely on positive performance and cash flow availability in the SMEs in Limuru Sub -County. 1.2 Statement of the Problem Small and medium-sized enterprises are unable or they find it hard to expand their Business operations due to high taxation by the government, many SMEs hence resort To tax evasion and many other non –compliance methods in order to maintain their Business operations. This can be evidenced by Ndemo (2015) who found that; the Majority of businesses particularly small and medium-sized enterprises are not registered And carry out business without both county and national government licenses. Using data Posted by KRA (2015), most Small and medium-sized enterprises have evaded tax Between 35% and 33.1 in 2012 and 2011 respectively. Furthermore, various studies (Shalfman et al., 2019; Mohammed & Hicham, 2018) have established that the taxation Environment surrounding SMEs is a vital element of the economy and requires close Monitoring to ensure vibrancy. According to Shlafman (2019) SMEs are vital Stakeholders in the economy and government agencies must create a favorable Environment for the good performance of such entities through appropriate taxation. Moreover, SMEs contribute 70% of all jobs in the economy and 35-55% of GDP in Developing and developed nations respectively. The research undertaken in regards to taxation and compliance has mostly focused on Large corporations and there is no particular focus on SMEs. There have not been any Empirical studies on the effect of taxation on the performance of small and medium- Sized enterprises in Mombasa County. Limited research in the field contributes to the Need for more studies on the topic. Some of the studies have focused on taxation (Newman et al., 2018; Ndemo, 2015; Zafiris, 2016; Mohammed & Hicham, 2018; Muturi, 2016; Ngek, 2018) and have investigated the association between taxation Compliance among SMEs, and taxation environment. Consequently, Statement of the Problem Small and medium-sized enterprises are unable or they find it hard to expand their business operations due to high taxation by the government, many SMEs hence resort to tax evasion and many other non –compliance methods in order to maintain their business operations. This can be evidenced by Ndemo (2015) who found that; the majority of businesses particularly small and medium-sized enterprises are not registered and carry out business without both county and national government licenses. Using data posted by KRA (2015), most Small and medium-sized enterprises have evaded tax between 35% and 33.1 in 2012 and 2011 respectively. Furthermore, various studies (Shalfman et al., 2019; Mohammed & Hicham, 2018) have established that the taxation environment surrounding SMEs is a vital element of the economy and requires close monitoring to ensure vibrancy. According to Shlafman (2019) SMEs are vital stakeholders in the economy and government agencies must create a favorable environment for the good performance of such entities through appropriate taxation. Moreover, SMEs contribute 70% of all jobs in the economy and 35-55% of GDP in developing and developed nations respectively. The research undertaken in regards to taxation and compliance has mostly focused on large corporations and there is no particular focus on SMEs. There have not been any empirical studies on the effect of taxation on the performance of small and medium- sized enterprises in Mombasa County. Limited research in the field contributes to the need for more studies on the topic. Some of the studies have focused on taxation (Newman et al., 2018; Ndemo, 2015; Zafiris, 2016; Mohammed & Hicham, 2018; Muturi, 2016; Ngek, 2018) and have investigated the association between taxation compliance among SMEs, and taxation environment. There is limited research on the effect of taxation of the performance of the SMEs in Mombasa County. Consequently, Statement of the Problem Small and medium-sized enterprises are unable or they find it hard to expand their business operations due to high taxation by the government, many SMEs hence resort to tax evasion and many other non –compliance methods in order to maintain their business operations. This can be evidenced by Ndemo (2015) who found that; the majority of businesses particularly small and medium-sized enterprises are not registered and carry out business without both county and national government licenses. Using data posted by KRA (2015), most Small and medium-sized enterprises have evaded tax between 35% and 33.1 in 2012 and 2011 respectively. Furthermore, various studies (Shalfman et al., 2019; Mohammed & Hicham, 2018) have established that the taxation environment surrounding SMEs is a vital element of the economy and requires close monitoring to ensure vibrancy. According to Shlafman (2019) SMEs are vital stakeholders in the economy and government agencies must create a favorable environment for the good performance of such entities through appropriate taxation. Moreover, SMEs contribute 70% of all jobs in the economy and 35-55% of GDP in developing and developed nations respectively. The research undertaken in regards to taxation and compliance has mostly focused on large corporations and there is no particular focus on SMEs. There have not been any empirical studies on the effect of taxation on the performance of small and medium- sized enterprises in Mombasa County. Limited research in the field contributes to the need for more studies on the topic. Some of the studies have focused on taxation (Newman et al., 2018; Ndemo, 2015; Zafiris, 2016; Mohammed & Hicham, 2018; Muturi, 2016; Ngek, 2018) and have investigated the association between taxation compliance among SMEs, and taxation environment. There is limited research on the Impacts of revenue targets on the performance and income tax of SMEs in Limuru Sub-County. 1.3 Objectives Of The Study This study was guided by the general and specific objectives as outlined. 1.3.1 General Objective The general objective of this study was to determine the impacts of revenue targets on performance and income tax of small and medium-sized enterprises in Limuru Sub – County. 1.3.2 Specific Objectives This study was guided by the following specific objectives: - i. To determine the effect of Income tax on the performance of small and medium-sized enterprises in Limuru Sub- County. ii. To evaluate the effect of Income Tax on the performance of small and medium- sized enterprises in Limuru Sub-County. iii. To assess the effect on the performance of small and medium-sized enterprises in Mombasa County. 1.4 Research Questions i. What is the effect of Income Tax on the performance of small and medium- sized enterprises in Limuru Sub - County? ii. What is the effect of Income Tax on the performance of small and medium-sized enterprises in Limuru Sub - County? iii. What is the effect on the performance of small and medium-sized enterprises in Limuru Sub - County? 1.5 Significance of the Study The current study sought to find out the Impact of revenue targets on the performance and Income Tax of small and medium-sized enterprises in Limuru Sub - County. Consequently, the findings of the research generated knowledge to tax administrators regarding the impact different forms of taxation have on the performance of SMEs in Limuru Sub - County. Government acknowledges the significance of the SMEs in Kenya and therefore will use the information and findings to create a favorable environment for the SMEs. Moreover,the study will provide KRA information regarding the impact of taxation on the growth of SMEs in Kenya. KRA as the designated revenue collection agency in Mombasa and Kenya in general Will use the information gathered to streamline the taxation process and become more Efficient in tax collection. On the other hand, stakeholders in academia will gain knowledge on the best practices For SMEs taxation in the country. Future scholars undertaking research in a similar field Will use the current research to augment their work. 1.6 Scope of the Study This academic research focused on the impact of revenue targets on the performance and Income tax of small and Medium-sized enterprises in Limuru Sub -County. The study is supposed to be focusing mainly on SMEs within Limuru Sub – County since they are representing the entire population of SMEs in the nation. Moreover, the study targeted SMEs within Limuru Sub-County as this Will enable the researcher manage the financial costs of collecting data from a wide area. Research will be undertaken for two months between March and April 2023 to collect Relevant data. 1.7 Limitations of the Study The researcher may face several limitations as some respondents being reluctant to provide The information due to fears that the information they provided could be used against Them or bear some adverse effects on the manufacturing firms and therefore may not Wish to participate in this study. This limitation is to be overcomed by an introductory letter From the KESRA reassuring them that the information will be strictly for academic purpose And will be treated with confidentiality. CHAPTER TWO LITERATURE REVIEW 2.1 Introduction This chapter reviews literature concerning the theoretical and analytical evidence on the underlying effect of taxation and the subsequent innovative tax coping mechanisms employed by the SMEs. First, in section 2.2, a review of the Concept of SMEs, relevance of SMEs to the development of national economy and socio-economic background of Nairobi County are presented. In section 2.3, an overview of tax and taxation are also presented. A discussion of tax multiplicity and types of taxations is made in subsections 2.3.1 and 2.3.2. In section 2.4, the concept of entrepreneurship is presented. Theories of entrepreneurship have been covered in section 2.5. A brief description of the models of innovation and creativity is presented in section 2.6. In section 2.7, the effect of taxation on the growth of SMEs is reviewed. Innovative tax copying mechanisms employed by SMEs has been dealt with in section 2.8. Critical literature reviews of the topics under consideration are further considered in section 2.9. A summary on the literature review, the research opportunity and the conceptual framework for the current study are discussed in section 2.10 and section 2.11. 2.2 The Small and Medium Enterprises 2.2.1 The Concept of Small and Medium Enterprises Small scale enterprises have so many definitions due to different criteria employed by different people and institutions in defining it. There is no single, uniformly accepted definition of a small firm (Storey, 1994). 13 Firms differ in their levels of capitalization, sales and employment. Hence, definitions which employ measures of size (number of employees, turnover, profitability, net worth, etc) when applied to one sector could lead to all-firm being classified as small, while the same size definition when applied to a different sector could lead to a different result. Scholars, researchers and international bodies have always attempted to provide a standard definition of SMEs. No such definitions have been accepted universally. However, the followings are some definitions of small and medium scale enterprises: the World Bank Document (Report No 71 14) of 1988, Nigeria defined small and medium enterprises as one whose total fixed assets (excluding land) plus cost of investment do not exceed ten million naira in constant 1985 price. Mead (1998) sees SMEs as firms with less than 50 employees and at leas half the output is sold. According to Bolton committee (1971) defined small and medium scale enterprise as a firm that meets the following three criteria: it has a relatively small share of their market place; it is managed by owners in a personalized way, and not through the medium of a formalized management structure and it is independent, in the sense of not forming part of a large enterprise. There are various criteria of size that might be used to define an SME (turnover, number of employees, capital base, profits, extent of imports and exports), and various definition have indeed been developed for application in a range of countries. The centre for industrial Research and development (1990) defined small scale industries as one whose total assets in capital equipment, plant and working capital are less than tow hundred and fifty thousand naira and employing fewer than fifty full-time workers. 14 Onwe (2006) observed that Central Bank of Nigeria (2002) defined SME as a firm with capital outlay of not more than N200 m. National Council of Industry (2003) defined small industry as a project with capital investment of over N1.5 million but not more than N50 million and/or work force of between 1 to 100 workers. A definition of small and medium scale enterprises which has enjoyed wider acceptance is the one given by the United States Committee for Economic Development (2002). It defined small scale enterprise as any enterprise that is characterized by, at least, two of the following features: management is dependent – usually managers are also the owners; capital is supplied and ownership is held by an individual or small group; area is localized; while workers and the owners are of one home or community, market need not be local; and the size of the firm is small relative to the industry. In fact, the concept, small scale enterprise often called small and ‗medium-size enterprise (SME) is relative and dynamic, hence there is no universal definition for small and medium scale enterprises. Researchers, because of this problem of definition adopt definitions for small and medium-scale enterprises, which are more appropriate to their particular target group. To this end, small scale enterprise within the context of this work is any business organization which has working capital between one hundred thousand naira and ten million naira excluding land and employs fewer than fifty full-time workers. Sule (1986) observed that definitions of SMEs vary across countries and business environment as a result of differences in industrial organization at different level of ‗economic development in 15 parts of the same country. Characteristics of SMEs identified by Sule include the following distinguishing factors: tax payers tend to be few, owner of the business is also the manager, transactions are based on cash payments and hardly bank payments, the businesses normally have a dynamic lifespan, and the places of business for SMEs are normally fixed but volatile and react to changes/demands. On accounting standards, SMEs tend to have little accounts or records SMEs have a focus on meeting local customers for their market reach and administratively, SMEs engage few or no professional unlike major companies run by professionals (Boune, 2007). 2.2.2 Relevance of SMEs to the Development of National Economy Small-scale enterprises are dominating other aspects of enterprises in the world economy and Kenya‘s in particular. According to Nwankwo (1992), it is estimated that probably up to 90 percent of all registered business organizations in Nigeria are in the category of small and medium scale enterprises. In the case of Ebonyi State, over 96 percent of the business organizations are small-scale businesses. The Kenyan scenario is not different either with hundreds of companies registered daily at the registrar of companies‘ house. Records available at KRA (2010) show that there are over nine hundred SMEs that make tax returns. The importance and contributions of small scale enterprises to national economy‘s growth cannot be over-emphasized. They play a crucial role in providing solid base for a country‘s social economic development. Small scale enterprises produce goods and services for both end and intermediate users and also utilize low capital cost for creating jobs especially in the fast growing service sector of the economy. 16 Liedholm and mead (1987) observed that small and medium scale enterprises provide productive employment and earning opportunities. Longnecker et‘al (1997) postulated that small scale enterprises in united state of America have created over 3 million new jobs in manufacturing between 1976 and 1986. SSES also play a vital role of introducing innovations. Records show that many scientific breakthroughs have originated with independent inventors and small organizations. Longenecker, Moore and petty (1997) suggest, on the basis of several studies by the U.S Department of commerce, that 50 percent of all innovations since world war if have coke from new and smaller firms. Ekhator (2001) found out that most countries in the world that have attained advanced stage in industrial development and did so because they started their industrial development with programmes in the small and medium scale enterprises. SMEs foster linkages within industries and between industries and other sectors of the economy, (Olusoji, 1999). SMEs can also, contribute to long run industrial growth by producing an increasing number of firms that grow up and out of small scale sector. They accelerate rural development and promote the utilization of domestic‖ resources by adapting to local markets and local sources of material. Enudu (1999) noted that small-scale enterprises make use of waste material from big industries for further production. Small business can be an aid to personal and national self-reliance. Ukeje (2003) noted that small-scale business enterprises contribute 70 percent of industrial employment in Kenyan economy though it accounts for only 10-15 percent of manufacturing output. In fact there abound many economic cum social roles SMEs play in the development of the national 17 economy. To this effect, policies that would facilitate their utilization should be adopted by concerned authorities. In realization of the advantages of promoting SMEs, Kenyan government is at the forefront in promoting the growth of SMEs in all parts of the country in partnership with development partners, financial institutions and enterprise agencies. In Nigeria, the Federal Government of Nigeria has continued to play pioneering and active roles in stimulating SMEs (Obitayo, 1991). The government has established many institutions to facilitate the growth of SMEs. These institutions include the National Directorate of Employment (NDE), the Family Economic Advancement Programme (FEAP) etc. The government also provided technical assistance to SSEs through its various agencies such as the Industrial Development Centre (IDCs) centre for Industrial Research and Development (CIR), Project Development Centre (PRODA), Small and Medium Scale Enterprise Development Agency of Nigeria (SMEDAN), Small and Medium Scale Enterprise Investment Equity Scheme (SMEIES) etc specifically, the government has played lead role in: Young Lee and Roger Gordon (2005) gave the following suggestions in their Background Paper for Tax Dialogue Conference,‘‘ that for SMEs to fully develop and use their potential, they need specific policy measures to ensure that technology services and infrastructure are provided‘‘. Further, research and development institutions that are publicly funded should be encouraged to target the technology needs of SMEs. Secondly, the problem of access to information may be attributed to the inadequacy of SME support institutions. The need for a supportive policy to encourage the establishment of documentation centers and information networks to provide information to SMEs at an 18 affordable price (Foluso, 2007). Thirdly, the government should come up with training for training managerial and technical courses for the small enterprises entrepreneurs. Equally, there should be business information centers (Terkper, 2007). Fourthly, government should come up with proper regulatory policies that are small enterprises friendly since many of what we have in Kenya; frustrate every effort of a junior entrepreneur. The policies we seem to have, seemed to cater for the well-established businesses. Since majority of small enterprises lack finance, government should establish friendly small loaning system. This would include low interests rates to ensure the continuity of these businesses (Foluso, 2007). 2.2.3 Socio-Economic Background of Nairobi County Nairobi is the capital city of Kenya with a thriving SMEs sector that exhibit both formal and informal characteristics. The SMEs in Nairobi‘s industrial area play a major role in providing products and services to a major population of Nairobi. They also contribute a great deal to the country‘s economic growth. Major players in the sector come from the middle and lower class levels of the society which comprises of the majority of the population in Nairobi living in Eastland, Eastleigh, Makadara, Mlolongo, South B Estate, sprawling Mathare slums, Kibera and Mukuru Kwa Njenga among others. 2.3 An Overview of Tax and Taxation Scholars, researchers and economists have always attempted to define and understand the term taxation. However, these groups of experts have not yet defined and standardized the meaning of 19 tax and taxation (Erosa, Gustavo & Walter, 2009). The origin of the terms tax and taxation has always been a subject of controversy among economists and researchers. Scanty literature on this subject has attempted to trace the first known system of taxation to Ancient Egypt in around 3000 BC - 2800 BC in the first dynasty of the Old Kingdom (McCluskey, William; Franzsen, & Riël, 2005). However, the controversy of taxation has also been compounded by the critical forms that existed then. Such obsolete forms of taxation include seigniorage( the tax on the creation of money), Scutage tax paid in lieu of military service- a non-tax obligation ), Tallage ( a tax on feudal dependents) and Tithe ( a tax-like payment (one tenth of one's earnings or agricultural produce), paid to the Church. By bringing theses historical issues on tax and taxation to the fore, and how these terms have been understood by generational scholars, key concepts have been identified and used (Arundel & Kabla, 1998). Anyanwu (1997) noted that taxation has three principal objectives, which are regulation of the economy and economic activities, raising of revenue for the government and controlling of income and employment. Revenue realizable form taxation depends on some factors but principally on the tax base and rate. Tax base refers to the specification of the minimum amount above which is taxable, while tax rate is the amount which is levied per unit of base. Tax bases simply are those objects upon which tax revenue are derived (Mansfield 1973). Tax system, therefore, should be consistent with over-all economic policy, which may include such objectives as favoring savings over consumption and raising private investment. Taxes no matter the type and how there are being administered bear effects on payer. Effects of taxation are the changes in the economy consequent upon tax imposition. Anyanwu (1997) contends that 20 the presence of tax distorts the pattern of production, consumption, investment, employment and other similar patterns for good or for bad and these distortions are collectively viewed as the effects to taxation. Lewis (2005) observed that an effective and efficient tax administration system is integral to any country‘s well being. The proper amount of tax must be collected in a timely manner and the enforcement powers of the tax administration must provide an even playing field for business by ensuring that all taxpayers meet their tax filing and paying requirements. The tax administration must balance its educational and assistance role with its enforcement role. The overriding goal is to foster voluntary compliance with the tax laws. This represents a significant challenge in a developing economy. Taxes may have a great variety of effects. They may cause some goods to become more expensive relative to others and so cause a change in the pattern of consumption. They may fail more heavily on some households than others, thus altering the distribution of net income. ―they may effect people‘s willingness to work and to save, and to take risks, that is, they may effect the total supply to resource s available to the economy‖, (Seddon 1973). Raymond & Jakob in their investigation carried out in Ugandan firms on ―Are corruption and Taxation Really Harmful to Growth? Firm Level Evidence‖: Journal of Development Economics (2007) studied the relationship between bribery payments, taxes and firm growth. Using industry-location averages to circumvent potential problems of endogeneity and measurement errors, and found that both the rate of taxation and bribery are negatively correlated with firm growth. A one-percentage point increase in the bribery rate is associated with a reduction in firm 21 growth of three percentage points, an effect that is about three times greater than that of taxation. This provides some validation for firm-level theories of corruption which posits that corruption retards the development process to an even greater extent than taxation. Bhatt (1973) noted that the tax system is an organic part of the economic system, and hence it is essential that there be some certainty and stability about its basic features. According to him, a large number of ad hoc change3 each year create a climate of uncertainty, which hampers productive effort and diverts valuable scarce resources towards speculative and other undesirable channels, as well as encouraging efforts to circumvent the government measures. Thus, the qualitative aspect of taxation in the conventional economic analysis is not much concerned with the revenue-yielding capacity a tax but with its effects on economic unites who are subjected to the payment of tax. 2.3.1 Tax Multiplicity Tax policy in both developed and developing countries has been largely used to generate maximum revenue for the government and as a result its use for optimal allocation of resources or redistribution of income is being neglected. Anyanwu (1997) noted that tax authority in Nigeria has concentrated on the manipulation of the rates and tax bases in order to generate enough revenue for the government. According to Anyanwu, this has led to imposing of different types of taxes and levies by tax authorities. These different taxes which should have otherwise come under one major type of tax but are split into many forms are in, this work refereed to as ―multiple tax‖. 22 Ndokwu (1988) observed that so many taxes are imposed at different or supplementary rates and it involves different tax bases and different times of payment. In Nigeria, Tax policy planning is not clearly assigned to specific unit rather than on long term studies, (Anyanwu 1997). Utomi (2000) in line with this view noted that Nigeria has a confused taxation philosophy. This results in proliferation f taxes and tax laws hence tax multiplicity. Awake (2003) observed that over 300 different taxes are paid by tax payers in some African countries, while in some Asian countries, local officials impose dozen of illegal charges from fees for, growing bananas to taxes on slaughtering pigs-either to top up (increase) the local finances or pad their on pockets. Taxes generally provide basis for government revenue, which help them in carrying out their functions. This is why Ojo (1996) defined tax as a means by which government appropriate part of private sector‘s income and expenditure as its revenue for the purpose of meeting recurrent expenditure and creating public capitals formation towards the development and growth of goods and services of the economy. A good tax possesses the following qualities: fairness, convenience, simplicity and minimum cost of collection and minimum distortions. Ravelo (1980) noted that taxes should be chosen so as to minimize interference with economic decisions in otherwise efficient markets. Imposition of excess burden should be minimized. Again, a good tax system should permit efficient and non-arbitrary administration and it should be understandable to the taxpayer. Taxes therefore are known to play important role in the process of development of an economy. This is the role of providing finance for government expenditure. There are three main objectives of taxation. 23 These include raising of revenue for the government, regulating the economy and economic activities, and controlling of income and employment. To tax is to impose a financial charge or other levy upon a taxpayer (an individual or legal entity) by a state or the functional equivalent of a state such that failure to pay is punishable by law. Taxes are also imposed by many sub- national entities. Taxes consist of direct tax or indirect tax, and may be paid in money or as its labor. A tax may be defined as a pecuniary burden laid upon individuals or property owners to support the government. A tax "is not a voluntary payment or donation, but an enforced contribution, exacted pursuant to legislative authority" and is "any contribution imposed by government, whether under the name of toll, tribute, impost, duty, custom, excise, subsidy, aid, supply, or other name‖ (Erosa & Ventura,2009). The legal definition and the economic definition of taxes differ in that economists do not consider many transfers to governments to be taxes. For example, some transfers to the public sector are comparable to prices. Examples include tuition at public universities and fees for utilities provided by local governments. Governments also obtain resources by creating money (e.g., printing bills and minting coins), through voluntary gifts (e.g., contributions to public universities and museums), by imposing penalties (e.g., traffic fines), by borrowing, and by confiscating wealth. From the view of economists, a tax is a non-penal, yet compulsory transfer of resources from the private to the public sector levied on a basis of predetermined criteria and without reference to specific benefit received. In modern taxation systems, taxes are levied in money, but in-kind and corvée taxation is a characteristic of traditional or pre-capitalist states and their functional equivalents. The method of taxation and the government expenditure of taxes raised is often highly debated in politics and economics. Tax collection is performed by a government agency such as Canada Revenue Agency, the Internal Revenue Service (IRS) in the United States, or Her Majesty's Revenue and Customs (HMRC) in the UK and KRA in Kenya. When taxes are not fully paid, civil penalties (such as fines or forfeiture) or criminal penalties (such as incarceration) may be imposed on the non-paying entity or individual. In Kenya, taxation is the single largest source of government budgetary resources. A study carried out by Moyi & Ronge (2006) found out that between 1995 and 2004, tax revenue constituted 80.4% of total government revenue (including grants). Taxation is used to raise sufficient revenue to fund public spending without recourse to excessive public sector borrowing. Secondly, it is used to mobilize revenue in ways that are equitable and that minimize its disincentive effects on economic activities (ibid). Unfortunately, over the same period, Kenya has moved from being a low tax burden country to a high tax burden country, yet the country still faces the obvious need for more tax revenues to maintain public services. According to Sessional Paper No 1 of 1986 (GOK, 1996), the Kenyan Government initiated essential policy goals: raise the tax revenue-GDP ratio from 22% in 1986 to 24% by the period 1999/2007, promote saving and investment by placing a greater burden on taxation of consumption , devise a tax structure that distributes income equitably and promotes rural-urban balance, make industry more competitive through reviews of import duties and export compensation, design a buoyant and elastic tax system that keeps revenues expanding at the 25 same pace with income growth without annual changes in rates, Reduce compliance and administrative costs through low and rationalized tax rates, wider tax bases, self-assessment systems and taxpayer education and services. These reform goals gave birth to the Kenya Revenue Authority (KRA) which was incorporated in 1995. Thus, KRA amalgamated the five main revenue departments that were initially in the Ministry of Finance namely Customs Duty, Excise Duty, Sales Tax, Income Tax and Corporate Tax). According to Karingi et al (2005), there have been criticisms leveled against KRA resulting to the problem of ambitious and rapidly changing tax/GDP targets that are externally induced as well as the failure to reform local government taxation. One of the mistakes of the Kenyan tax reform, Karingi continues, is poor sequencing, which results in policy reforms that hurts the growth of SMEs. Kenya, like many other developing countries, seeks to apply the tax weapon so as to meet the objectives of raising enough revenue. The three main factors of production –labor, capital and land- are used in varying proportions in the productive process of the economy. The returns to these factors- wages, profits and rent –are taxed if the objectives of the tax policy are to be met. In Kenya, the tax system has mainly concentrated on taxing individual income (Personal .Income Tax-PIT), profits (Corporate Income Tax-CIT) and goods and services (VAT, excise duties). However, when this is done progressively, it may hurt some important part of the economy which includes the SMEs. King & McGrath (2002, observed that compared with a sample of low-income sub-Saharan countries, Kenya‘s tax/GDP ratio is higher than the sample average. The imbalance between government revenue and expenditure results in large and chronic fiscal deficits. In theory, the financing of a deficit especially through foreign borrowing or additional foreign financing may have considerable effects on interest rates, the balance of payments and the external value of the currency, in this case the shilling. This has prompted Kenya to initiate reforms in the tax structure with diverse objectives. Unfortunately, the reform process began at a time when the macro-economic environment was unstable thus inhibiting the growth of SMEs. Although has Kenya embarked on massive tax reforms since1986, little is known about the actual effect of such tax to the growth of SMEs. It is not known how the reforms have affected each tax source. The current study attempts to fill this research gap. If well designed, taxation has the capacity to raise the incremental savings ratio, which is one of the main determinants of growth (Prest, 1985). The growth in tax revenue must approximate the growth in expenditure for the players of economy to hold (World Bank, 1990). Osoro ( 199) identifies the main elements of the tax reforms programmes beneficial to the growth of SMES which include: Imposing a small number of taxes with the broadest possible base and moderate rates ,using VAT to replace commodity taxes in order to minimize disincentives for investments and exports , not only avoiding raising taxes on the poor, but also reducing their tax burden-this is achieved by levying excise duties on luxury items and exempting foodstuffs to protect the low-income groups., avoiding tax incentives and shifting to broader, simpler tax bases on which lower rates are applied, minimizing corporate tax evasion 27 (some countries levy minimum taxes on a company‘s net worth).,lowering distortions that reduce economic welfare and growth (World Bank, 1990). Unfortunately, in Kenya more often, tax systems has emphasized the introduction of either new taxes or new rates on existing bases, more stringent administrative changes and the need to widen tax bases and reduce exemptions (Thirsk, 1991). According to Musgrave (1987), taxation issues include impact of alternative taxes on saving and investment and the resultant challenges for micro balance of the economy. Reforms according to him should address the issue of equity in the distribution of the tax burden as well as composition of the tax structure. Kenya‘s tax programme, Wagacha (1999) argues, should seek to (a) improve the efficiency and productivity of taxation, (b) improve tax collection and administration while lowering the rates, and (c) gain tax effectiveness through greater tax elasticity. On the basis of tax/GDP , this author observes that Kenya‘s tax burden (averaging 26.6%) is high by international standards and therefore the ultimate objective of a tax reform scheme should be to lower the excessive tax burden and efficiency costs of taxation. 2.3.2 Types of Taxation Taxes consist of direct tax or indirect tax. In the current study, both direct and indirect taxes will be considered since it is easier to measure. According to Osambo (2009), direct taxes include income tax, VAT, customs and excise, national insurance, corporation tax and excise duties. 28 Income tax is probably the most important tax of all, raising well over a quarter of all tax revenue. It is charged on all income, but the rate increases the more income is earned. The first part is tax-free, but then once you have earned this personal allowance the tax rate is 10% for the next chunk of income. The level at which the rate changes is termed the tax band and these tend to be changed in the budget each year to keep up with inflation. Income tax is collected by the Central governments (Cordes, Hertzfeld & Vonortas, 2004). In Kenya, Income tax is a direct tax charged on business income, employment income, rent income, pensions, and investment income. There are many methods applied in the collection of income tax. Which include PAYE, withholding tax, installment tax, advance tax, presumptive income tax and the direct payments to the Commissioner of Domestic Taxes for balance of tax and arrears. According to KRA (2009), PAYE is a method for collecting tax at source from individuals in gainful employment. In this type of taxation, the employer is empowered to deduct tax according to the prevailing rates of tax from their employees‘ salary or wages on each payday for a month then remit it to the Paymaster. Withholding tax is a form of income tax deducted at source from the following sources of income: interest, dividends, royalties, management or professional fees, commission, pensions, and rent received by non-resident persons. Advance tax which was introduced in 1996, is a tax paid in advance before a public service vehicle or commercial vehicle is licensed. The tax is applicable to vans, pickups, trucks, Lorries and saloons. 29 The main goal of income tax has been to enhance collection by broadening the tax base. However, when this tax is done excessively, it hurts the most contributory agents of the economy (Wanjohi & Mugure, 2008). VAT (Value added tax) is a tax on spending and is therefore an indirect tax. VAT is charged at every stage of the production and the only people who pay VAT as a tax are the consumers. A firm has to keep a record of all the VAT they have paid on their supplies and all the VAT they have collected on their sales. The current rate of VAT in Kenya is 16 % (KRA, 2011). VAT was introduced in Kenya in 1990 to replace sales tax. Since 1991, VAT has been broadened to cover the service sector. Stringent measures includes the raising of the minimum turnover level for compulsory registration from Ksh10, 000 to Ksh40, 000 and introducing stiff penalties for defaulters in the following areas: late VAT returns, failure to issue VAT invoices and failure to maintain proper books of account, an aspect of VAT that elicited much interest from the taxpayers especially the SMEs (Nyamunga, 2001). The national insurance is paid by both employers and employees. According to Cordes, Herzfeld Vonortas (2004), national insurance is a fund maintained by government to pay out for those unemployed and when one reaches retirement age. Corporation tax is the main business tax. This is a tax charged on company profits and the rate varies according to the size of the business. It is effectively an income tax for business as their income is their profit. Business do also have to pay local business taxes (business rates) to local authorities in the area they are located in, but corporation tax is collected by the national government ( Kortum & Lerner ,1999). In Kenya, corporation tax is income tax levied on 30 corporate bodies such as Limited Companies, Trust, and Co-operatives. Resident companies are taxable at a rate of 30 % while non-resident companies are taxable at the rate of 37.5 % on the taxable income KRA (2009). Installment tax is paid by both individual and corporate taxpayers who have tax payable for any year, except in the case of those individuals whose tax liability for a particular year is fully covered under PAYE, or whose final tax liability is below Ksh 40000. Excise duties are also taxes on spending and are termed indirect taxes, but they are taxes on specific goods. Excise duties are charged on alcohol, tobacco, and petrol and gambling. Theses taxes tend to be increased each year in the Budget. This is because they are usually set at a fixed rate and so need to be increased to ensure that the revenue from them keeps up with inflation. Excise duties are intended to try to reduce consumption because of the harmful social costs that may be generated as a result (pollution from petrol, etc.). Since 1991, the coverage of excise duties has expanded from domestic production to include imports. Excise duties were rationalized to cover the luxury goods tax element on wine, beer, spirits, mineral water, tobacco products, matches, luxury passenger cars and minibuses. Automotive fuels and cosmetics were also introduced into the excise tax net (Nyamunga, 2001). Allingham & Sandmo (2004) identifies various taxes that are synonymous with the informal sector. According to them, there are two types of direct presumptive taxes: –withholding and direct tax on all or below threshold businesses. On the other hand, presumptive withholding taxes 31 requires formal sector tax collector such as customs (imports or exports), marketing agency (agricultural, forestry, etc products), government or private corporation (goods and services purchases), corporation (dividends), financial institution (interest income, pensions, etc). One of the key objectives of tax reforms in Kenya is to ensure that the tax system can be harnessed to mitigate the perpetual fiscal imbalances. This can be achieved through tax policies intended to make the yield of individual taxes responsive to changes in national income. In addition, it is expected that the predominant taxes in the revenue would be those with highly elastic yields with respect to national income (Kinyanjui & Moyi, 2008). Incidentally this assertion can not hold true when SMEs continue to suffer heavy taxation burdens. 2.4 Concept of Entrepreneurship Entrepreneurship is an outcome of complex balancing of opportunity initiatives, risks and rewards (Mamun, 2000). Entrepreneurship is as a process by which people pursue opportunities, fulfilling needs and wants through innovations, without regard to the resources they currently control. Entrepreneurial resource is vital ingredient of economic development whereas a key element of economic development is that the 'people of the country' must be major participants in the process that brought about changes in structure of economic and population growths along with consumption pattern. According to North (1990), through the process of entrepreneurship, it is possible to augment the scope of capital formation, employment generation and facilitate industrialization in a country. In addition, entrepreneurship acts as a powerful tool of employment generation, raising productivity through innovation, facilitating transfer of 32 technology, playing key role in commercializing new products, redistribution of wealth and income, earning foreign exchanges and promoting social welfare (North ,1990). The concept of entrepreneurship as stated by Rauch & Frese (2000) is multifaceted and used in a wide variety of contexts. At its heart are entrepreneurs, i.e. persons that are believed to have characteristic traits or behave in some characteristic way. On the basis of these characteristic traits entrepreneurship is described as an innovator who undertakes the new combinations of factors of production. Innovation may occur in the form of: i) the introduction of a new goods, ii) the introduction of new method of production, iii) the opening of a new market, iv) the conquest of a new source of supply of factors of production and v) the reorganization of any industry. Entrepreneurs are specially motivated and talented type of individuals who are to see potentially profitable opportunities and tend to exploit them (Saha, 1989). It is recognized that mere existence of resources does not guarantee economic growth (Purhit and Rahman, 1995). Experience shows that progress is basically the human effort and it takes human agents to mobilize capital, to exploit natural resources to create new markets and to carry on trade (Frederick and Myers, 2002). According to J.A. Schumpter entrepreneurship is the central figure of the development process because the entrepreneur in the modern complex economic world can create opportunities for production technology, by expanding or discovering new market, new product, new source of resources, etc. All these activities will embrace risk and uncertainties and at the same time will increase the demand for higher or increased investment in the economy. This demand for increased investment will necessitate higher capital accumulation and thereby the demand for increased rate of savings in the economy. The cumulative effects of all 33 these factors will increase level of income ands total production of goods and services in the economy. In other words, in totality, the net result of expansion in the volume of economic activities will lead to growth in national economy and if a proper and equitable distribution policy can be formulated by the state to suit the real development in the economy will take place (Saha, 1989). 2.5 Theories of Entrepreneurship Entrepreneurship theories and research remain important to the development of the entrepreneurship field. Several theories have been put forward by scholars to explain the field of entrepreneurship. The current study examines three entrepreneurship theories with a bias on the growth of SMEs. These are: (1) Economic entrepreneurship theory, (2) Psychological entrepreneurship theory and (3) Sociological Entrepreneurship theory. 2.5.1 Economic Entrepreneurship Theory The economic entrepreneurship theory has deep roots in the classical and neoclassical theories of economics, and the Austrian market process (AMP). However, because of criticisms leveled against the classical and neo-classical conjectures led to the Austrian Market process (AMP) which was a model influenced by Joseph Aloi Schumpeter (1934). Schumpeter (1934) described entrepreneurship as a driver of market-based systems. To him an important function of an enterprise was to create something new which resulted in processes that served as impulses for the motion of market economy. Murphy, Liao & Welsch (2006) contend 34 that the theory offered a logic dynamic reality. In explaining this, they point to the fact that knowledge is communicated throughout a market system (e.g. via price information), innovation transpires, entrepreneurs satisfy market needs, and system-level change occurs. If an entrepreneur knows how to create new goods or services, or knows a better way to do so, benefits can be reaped through this knowledge. Entrepreneurs effectuate knowledge when they believe it will procure some individually-defined benefits. Fiet, (2002) held that entrepreneurs are incentivized to use episodic knowledge (that is, possibly never seen before and never to be seen again), to generate value. Thus, the AMP was based on three main conceptualizations (Kirzner, 1973).The first was the arbitraging market in which opportunities emerge for given market actors as others overlook certain opportunities or undertake suboptimal activity. The second was alertness to profit-making opportunities, which entrepreneurs discover and entrepreneurial advantage. The third conceptualization, following Say (1803) and Schumpeter (1934), was that ownership is distinct from entrepreneurship. In other words, entrepreneurship does not require ownership of resources, an idea that adds context to uncertainty and risk (Gartner, 2004). These conceptualizations show that every opportunity is unique and therefore previous activity cannot be used to predict outcomes reliably. (Casson, 2005) contends that an entrepreneur is the prime mover in economic development, and his function is to innovate, or to carry out new combinations. Anyone who performs this function is an entrepreneur, whether they are independent or dependent employees of a company. However, while the causes generating opportunities are unexplained in the entrepreneurship literature, a generation of scholars led by Shane and Ulrich (2004) examined the relationship among the entrepreneur, product development and technological innovation. The studies noted 35 that the technology opportunity set is endogenously created by investments in new knowledge (Warsh, 2006). However, not only does new knowledge contribute to technological change, it also creates opportunities for use by third party firms (Jaffe, 1989), often-new ventures (Shane, 2001). The creation of new knowledge gives rise to new opportunities through knowledge spillovers; therefore, entrepreneurial activity does not involve simply the arbitrage of opportunities (Kirzner, 1973) but also the exploitation of new opportunities created but not appropriated by incumbent organizations (Acs, Audretsch and Feldman, 1994). In the current study, just like suggested in the economic entrepreneurship theory by Schumpeter (1934) who described entrepreneurship as a driver of market-based systems, mitigating the adverse effect of taxation requires innovation which is basically dependent on entrepreneurship ,creating of new knowledge ,risk taking and management ,adaptability and leveraging technology. 2.5.2 Psychological Entrepreneurship Theory The level of analysis in psychological theories is the individual (Landstrom, 1998). These theories emphasize personal characteristics that define entrepreneurship. Personality traits need for achievement and locus of control are associated with entrepreneurial inclination which involves risk taking, innovativeness, and tolerance for ambiguity. The essence of psychological or personal theory is the difference in individuals‘ attitude. According to this theory the difference in attitude i.e. the internal attitude and ability to judge and forecast the situation lead a man to become a successful entrepreneur. 36 Coon (2004) defines personality traits as ―stable qualities that a person shows in most situations‖. Coon argues that there are enduring inborn qualities or potentials of the individual that naturally make him an entrepreneur. Some of the characteristics or behaviors associated with entrepreneurs are that they tend to be more opportunity driven (they nose around), demonstrate high level of creativity and innovation, and show high-level of management skills and business know-how (Rauch and Frese 2000). Coon (2004) says that entrepreneurs have been found to be optimistic, (they see the cup as half full than as half empty), emotionally resilient and have mental energy, they are hard workers, show intense commitment and perseverance, thrive on competitive desire to excel and win, tend to be dissatisfied with the status quo and desire improvement, entrepreneurs are also transformational in nature, who are life long learners and use failure as a tool and springboard. They also believe that they can personally make a difference, are individuals of integrity and above all visionary. David McClelland‘s theory (1961) on need for achievement explained that human beings have a need to succeed, accomplish, excel or achieve. Entrepreneurs are driven by this need to achieve and excel. In his theory McClelland emphasized the relationship of achievement motivation or need for achievement (Pervin, 1980). According to McClelland, one would expect a relatively greater amount of entrepreneurship in a society if the average level of need achievement in a society is relatively high. Because having a high achievement encourages an individual to sit challenging goals, work hard to achieve the goals and uses the skills and abilities needed to accomplish them (Pervin, 1980). Moreover, it is the inner drive of individuals that propels them to work more and to achieve something for their own interest by taking personal risk (Islam and Becker, 2001). Need for achievement then, reflects a strong goal orientation, an obsession with job or task to be done. Consequently, McClelland advocates increasing level of needachievement in a society in order to stimulate entrepreneurship and economic growth (Frese, 2000). Finally, according to McClelland, entrepreneurs are activated by the high extent of achievement motivation and he also stated a desire to do well, not so much for the sake of social recognition or prestige, but for an inner feeling of personal accomplishment, induce people to be an entrepreneur (Frese, 2000). An entrepreneur‘s need for achievement drives him to become innovative by devising tax coping mechanisms in order to survive in the business engagements and excel. This is what motivated the author to adopt the David McClelland‘s theory (1961). 2.5.3 Sociological Entrepreneurship Theory These are theories based on sociological aspects. This is because socio-cultural factors have a substantial influence in creating entrepreneur as well as entrepreneurship (Gartner, 2004). Moreover, social and cultural factors places a high value on innovation, risk taking and independence is more likely to produce entrepreneurial events than a system with contrasting values (Mamun,2000). Among these type of theories Max Weber‘s protestant values is ancient one. In this theory Weber argued that protestant or Calvinistic logic or values were instrumental in promoting capitalist enterprise. These values included, first of all, an emphasis on the inherent goodness of work itself. A person‘s work was regarded as a calling in the very literal rendering of the concept of vocation. Moreover, the experience of financial rewards from one‘s work was 38 regarded as a manifestation that one was blessed by God, a number of elect few predestined to share this grace. However, money created temptations to the flesh, whose yearnings were to be suppressed. Protestant values called for self-restraint and deferral of gratification. By investing one‘s earnings in the form of capital, one could practice such self-denial. Over a period of many years, repeated investment of earnings created the capital base for the take off of Western societies into the economic break-through of the industrial revolution (Mamun,2000). A previously stated in this study, social and cultural factors is an important ingredient on innovation, risk taking and independence for a holistic entrepreneurial status. Just in the same vein, the current study envisions that entrepreneurship will thrive well in a climate where tax burden is reduced. 2.6 Models of Innovation and Creativity 2.6.1 Schumpeter's Innovation Model Schumpeter's model is dynamic system that continually generates change and technological progress. Schumpeter's model is a dynamic one which describes an equilibrium path that the economy follows over time, not the stable equilibrium described by the familiar supply and demand models that were in vogue when Schumpeter first described his concept of creative destruction early in the twentieth century. Schumpeter described the capitalist economy as a "perennial gale of creative destruction" in which each firm sought to gain an advantage in the marketplace through innovation. He complained that "the problem that is usually being visualized is how capitalism administers existing structures, whereas the relevant problem is how it creates and destroys them" (Schumpeter, 1934). Each innovation, such as a more attractive 39 design, a lowering of production costs, a new product, a new source of supply of inputs or raw materials, or improved management methods was pursued because it held the possibility of generating higher profit for the innovating firm. Such creative activity also destroyed the monopoly power that its competitors had gained by means of their earlier innovations. Each innovator's gain is, therefore, only temporary because the creative innovation of its competitors will, sooner or later, destroy its hard-earned market power. This continual creation and destruction prevents permanent monopolies from developing, and in the process, society enjoys continuous technological progress. Creative destruction was, according to Schumpeter, the source of economic growth and the enormous increases in living standards that the world was experiencing in the early 1900s (Lewer and Van den Berg, 2004). 2.6.2 A Systems Theory of Creativity This Theory was advanced by Mihaly Csikszentmihalyi (1988) by relating creative effort by individuals to the state of the domain they are working in and the characteristics of those who assess the worth of the creative endeavor in the field concerned. According to Mihaly Csikszentmihalyi, the environment has two salient aspects: a cultural, or symbolic, aspect which here is called the domain; and a social aspect called the field. Creativity is a process that can be observed only at the intersection where individuals, domains, and fields Source: Csikszentmihalyi (1999) For creativity to occur, a set of rules and practices must be transmitted from the domain to the individual. The individual must then produce a novel variation in the content of the domain. The variation then must be selected by the field for inclusion in the domain. Creativity occurs when a person makes a change in a domain, a change that will be transmitted through time. Some individuals are more likely to make such changes, either because of personal qualities or because they have the good fortune to be well positioned with respect to the domain – they have better access to it, or their social circumstances allow them free time to experiment 2.7 The Effect of Taxation on the Growth of SMEs 2.7.1 Effect of Taxation on the Costs of Operation of Small and Medium Enterprises. Arinaitwe (2006) says that the desired capital stock depends not only on output, but also on the costs associated with investments. In other words, an economy on a rapid growth path attracts a high rate of investment, while a stagnant or shrinking economy offers no inducement for net investment aimed at the market. From this basic condition one can readily incorporate tax considerations into the analysis. In particular, tax elements heavily influence costs of operation, which is the cost per year of deploying capital in an investment project. From the point of view of the investor, the effective return on capital is diminished to the extent of tax due on company income. However, the cost of paying company tax is offset by any benefit which may accrue to the investor from tax incentives such as tax holidays, preferential tax rates, investment credits, or capital allowances in excess of economic depreciation. These benefits arise at different points in time and vary year to year. To handle this complexity, the standard approach is to take the present discounted value of the tax benefits, per unit of the investment outlay. Borgarello, Marignani, & Sande, 2004) argues that investment can be financed by equity or debt. Hence, the overall cost of funds depends on both the tax rate on debt financing and the risk adjusted real rate of return required by entrepreneurs who provide equity financing. In this framework, investment takes place as long as the gross return on additional investment exceeds the tax-adjusted cost of capital. In effect, the hurdle value of investment rises with the company tax rate and the tax on dividends, and falls with the value of the tax incentive package. A higher cost of capital reduces the set of viable investment projects. It also provides an incentive for companies to pursue more labor-intensive projects. Conversely, a lower cost 42 expands the set of viable investment projects, and favors capital-intensive projects. The net impact of tax hence breaks on job creation. The theoretical effect of taxation on investment is mediated by three other considerations. First, the gestation period for many investments may span several years, particularly for large projects. So there can be substantial lags before tax policies to stimulate investment have an actual impact. (Still, policy changes that worsen profitability may provoke an immediate cessation of planned investments.) Second, recent models that highlight the effect of uncertainty show that investors may defer projects even if they are fundamentally viable. Faced with substantial uncertainty about economic stability or the sustainability of pro-investment policies, along with irreversible startup costs, investors may choose to wait and see how events unfold before committing funds. Implicitly, they demand a higher hurdle rate consisting of the standard value. The result may be a very sluggish investment response. The antidote is to reduce uncertainty by establishing a track record of dependable policy management. Third, liquidity constraints and imperfections in the financial markets can enhance the effectiveness of tax cuts. The neoclassical model assumes that investors have access to debt and equity financing at a market-determined cost of funds (adjusted for risk). This is a reasonable assumption for SMEs. But for many companies the main source of funds for investment is retained earnings. In this case, tax cuts can foster investment by augmenting the company‘s net cash flow, providing the means to take advantage of viable investment opportunities that otherwise would be missed for lack of finance. 2.7.2 To Compare Taxation Effect on the Growth of Varying Small and Medium Enterprises A comparison of effective average tax burdens for companies located in different jurisdictions (varying small and medium enterprises) was carried out by (Spengel, 1995; Jacobs and Spengel, 1996; Meyer, 1996; Stetter, 2005; Gutekunst, 2005, Hermann, 2006). The effective average tax burden is derived by simulating the development of a corporation over a certain period. For the computation of the effective average tax burden the entrepreneurs use the economic data of the corporation and tax data as inputs. The entrepreneurs compare effective average tax burdens for companies over a period of ten years. According to this model, the effective tax burden is the difference between the pre-tax and the post-tax value of the firm at the end of the simulation period. The value of the firm is represented by the equity, which includes the capital stock and the cumulative net income of each of the ten periods. At the end of period ten, the tax value of assets and liabilities may differ from their fair value, depending on the tax rules which are to be applied. These hidden reserves and liabilities are added to the taxable income in period ten and are taxed accordingly. As a consequence, only the effects of different tax accounting rules on the liquidity are taken into account. Remaining loss carry forwards at the end of the simulation are dissolved liquidity-related whereas a devaluation of 50 per cent is made if there are no restrictions for the use of loss carry forwards and a devaluation of 75 per cent if there are any restrictions. The computation of the absolute effective average tax burden requires two steps. In the first step, the pre-tax value of the firm at the end of the simulation period is calculated. The pre-tax value of the firm is derived from the estimated cash flows and the value of the net assets at the end of the simulation period. The cash flows are derived from estimates for the cash receipts (sales and other receipts, gains upon the disposal of assets, interest and dividend income) 44 and expenses (wages and pension payments, expenses for material, energy consumption and other expenses, new investment, interest expenses and distributed profits) covered by the corporate planning model. The value of the net assets at the end of the simulation period is computed by deducting the liabilities of the corporation from the assets. Both the assets and the liabilities are valued at calibrated parameters that are the same in each country. For assets we use replacement prices and for liabilities nominal values. Pre-tax cash flow at the end of the simulation period + Value of the net assets at the end of the simulation period (= assets in the capital stock at replacement prices – liabilities in the capital stock at nominal values) = Pre-tax value of the firm at the end of the simulation period. In the second step, we calculate the post-tax value of the firm at the end of the simulation period. The determination of the post-tax value of the firm only has cash flow effects and no impact on the value of the net assets. The post-tax cash flow is derived in each period by deducting the tax liabilities from the pre-tax cash flow. In order to calculate the absolute amount of tax liabilities, receipts and expenses enter into the tax balance sheet and/ or into the tax profit and loss account following national taxation rules (e.g. regarding the computation of depreciation allowances). The reduction of the cash flow due to tax payments (liabilities) also has an impact on the balancing investment or credit and the connected interest receipts or credits. By taking into account these tax-induced effects on the interest income or expense of each period, the deferral of tax payments is integrated 15 into the model. Hidden reserves and liabilities are only relevant for taxation matters at the very end of the simulation. Finally, referring to the tax rates, the calculations consider statutory linear as well as progressive tax rate structures. In the case of progressive rates – relevant for special provisions for SMEs - 45 the tax rates enter into the model as functions of the relevant income or net assets (non-profit taxes). 2.8 Innovative Tax Copying Mechanisms Employed by SMEs 2.8.1 Business Security Measures in Line with Tax Avoidance The Entrepreneur Magazine Small Business (1995), tax avoidance refers to the legal means by which taxpayers can reduce their tax bill and is a legal utilization of the tax regime to one's own advantage. Tax avoidance is the legal utilization of the tax regime to one's own advantage, to reduce the amount of tax that is payable by means that are within the law. This is the legal right of an individual to decrease the amount of what would otherwise be his taxes or altogether avoid them, by means which the law permits, cannot be doubted (Hoover, 2000). Milliron and Toy (1988) predict that a rational taxpayer will avoid tax as long as the pay-off from avoiding is greater than the expected cost of taxation. Early economic scholars (Allingham and Sandmo, 1972) treat taxpayers as perfectly moral, risk-neutral or riskaverse decision-makers who maximize utility. Within this framework, factors that determine the monetary cost of compliance, like the tax rate, detection probability, level of income and penalty structure, drive compliance behavior. Milliron and Toy (1988) point out that more recent extension to these arguments have been achieved by ―relaxing assumptions, focusing on specific issues, and utilizing more sophisticated techniques. According to Falkinger (1988) the taxpayer and government exchange relationship within an avoidance setting. Falkinger maintains that there is some theoretical support for tax avoidance or a rationalization of past behavior. He believes that inequity as a rational causal factor of avoidance becomes more credible at a low tax level. Other researchers have extended 46 early economic models to include 1) the taxpayer‘s incentive to purchase tax advisory services (Beck et al., 1996), 2) the effect of practitioners on tax avoidance (Klepper et al., 1991; Scotchmer, 1989), and 3) the effect of the tax administration (Scotchmer and Slemrod, 1989). Weigel et al. (1987) argue that the absence of motivational concepts suggests the inadequacy of expected utility in this context, as economic deterrence models tend to assume motivation as given and behavior as primarily responsive to consequent costs and benefits. They point out that the plausibility of this assumption is questioned by the lack of empirical support and the criticism it has provoked. According to Fiscal psychologists, during the last two decades, policymakers and social scientists have recognized that tax avoidance is a behavioral phenomenon. Webley et al. (1991) categorize behavioral theories into two types. The first are integrative or frameworks of the taxpaying process, within which data about tax avoidance can be organized. Examples of this kind include Lewis (1982), Greenland and Van Veldhoven (1983), and Smith and Kinsey (1987). The second category is more straightforward applications of a socialpsychological theory to tax avoidance. Prospect theory was developed by Kahneman and Tversky (1979) using the psychological principles that govern the perception of decision problems and the evaluation of options. A descriptive theory of choice under uncertainty, it is viewed as an alternative to expected utility theory. In their original article, Kahneman and Tversky illustrate the concept of ―framing‖ with the example of an unexpected tax withdrawal from a monthly pay check, which is perceived as a loss, and not as a reduced gain. 47 2.8.2 Tax Planning Tax planning involves conceiving of and implementing various strategies in order to minimize the amount of taxes paid for a given period. Tax planning evaluates various tax options in order to determine when, whether, and how to conduct business and personal transactions so that taxes are eliminated or reduced (Dailey & Frederick, 1997). One method of tax planning is tax avoidance. There are many tax planning strategies available to a small business owner. However, regardless of how simple or how complex a tax strategy is, it will be based on structuring the transaction to accomplish one or more of these often overlapping goals: income, reducing, controlling, claiming, controlling and avoiding the most common tax planning mistakes ( Albert,2001). For a small business, minimizing the tax liability can provide more money for expenses, investment, or growth. In this way, tax planning can be a source of working capital. According to David & Jakabcin (1997), two basic rules apply to tax planning. First, a small business should never incur additional expenses only to gain a tax deduction. Second, a small business should always attempt to defer taxes when possible. Deferring taxes enables the business to use that money interest-free, and sometimes even earn interest on it, until the next time taxes are due. 2.9 Critical Literature Review 2.9.1 The Effect of Multiple Taxation on the Costs of Operation of Small and Medium Enterprises. According to Arinaitwe (2006), tax elements heavily influence costs of operation, which is the cost per year of deploying capital in an investment project. From the point of view of the investor, Arinaitwe argues that the effective return on capital is diminished to the extent of tax due on company income. Whereas this statement can be true, and the contents remain valuable, the conclusions on this particular aspect of the problem are at best partial in nature, and at worst not relevant without empirical evidence. Borgarello, Marignani, & Sande (2004) believe that investment takes place as long as the gross return on additional investment exceeds the tax-adjusted cost of capital. In effect, the hurdle value of investment rises with the company tax rate and the tax on dividends, and falls with the value of the tax incentive package. The authors treat investment as linear relationship only dependent on tax rate. However, investment is dependent on a number of variables. The theoretical effect of taxation on investment is mediated by three considerations: the gestation period, deference of projects and liquidity constraints and imperfections in the financial markets. Incidentally, investments can be determined by more than three factors. 2.9.2 To Compare Taxation Effect on the Growth of Varying Small and Medium Enterprises A comparison of effective average tax burdens for companies located in different jurisdictions (varying small and medium enterprises) is made (Spengel, 1995; Jacobs and Spengel, 1996; Meyer, 1996; Stetter, 2005; Gutekunst, 2005, Hermann, 2006). The effective average tax burden is derived by simulating the development of a corporation over a certain period. According to this arrangement, the effective tax burden is the difference between the pre-tax and the post-tax value of the firm at the end of the simulation period. Referring to the tax rates, the calculations consider statutory linear as well as progressive tax rate structures. In the case of progressive rates – relevant for special provisions for SMEs - the tax rates enter into the model as functions of the 49 relevant income or net assets (non-profit taxes). But the author offers no data to support the argument he is making. In the absence of any supporting evidence there is no way of judging the validity or reliability of his conclusions and this seriously undermines the value of the work. 2.9.3 Tax Avoidance Measures Allingham and Sandmo (1972) treat taxpayers as perfectly moral, risk-neutral or risk-averse decision-makers who maximize utility. Within this framework, factors that determine the monetary cost of compliance, like the tax rate, detection probability, level of income and penalty structure, drive compliance behavior. Although not a lot of primary research has been conducted to help support policy recommendations in this subject area, but Allingham and Sandmo (1972) are lacking depth in their explanation of both the data collection process and sample selection criteria. Consequently, the current work, in the absence of adequate detail, it is extremely difficult to assess the validity and reliability of the findings. Falkinger (1988) maintains there is some theoretical support for t ax avoidance or a rationalization of past behavior. He believes that inequity as a rational causal factor of avoidance becomes more credible at a low tax level. In order to determine causality, it is important to hold the variable that is assumed to cause the change in the other variable(s) constant and then measure the changes in the other variable(s). This type of research is very complex and the researcher can never be completely certain that there are not other factors influencing the causal relationship, especially when dealing with people‘s attitudes and motivations. There are often much deeper psychological considerations, which even the respondent may not be aware of. 50 2.10 Summary, Research Opportunity The present study will attempt to address some aspects of taxation not fully covered in the studies discussed hitherto. Taxation system has evoked great attention among many researchers in the World especially in Developed Countries. However most of the researchers concentrate more in studies which would increase the budgets ―bottom-line‖ in terms of huge revenue collection and enforcement efforts at the expense of studies that would address the effects of such taxes on the growth of SMES. Empirical evidence shows that there has been hostility between the taxpayers and tax collectors on issue relating to tax compliance (Migwi & Wanjohi, 2010). Previous studies have examined the impact of taxation on large and small enterprises in Africa and Kenya in particular on the growth of SMEs in Kenya. However, the reviewed literature does not adequately address ways to mitigate the high tax burden. The current study will therefore endeavor to examine the innovative tax coping mechanisms by SMEs in Nairobi County. 2.11The Conceptual Framework In this study, the relationship between the dependent and the independent variables will be investigated. These variables are as illustrated by Figure 2.1. DIAGRAM As derived from the taxation process models, the current study perceives the growth of SMEs as the dependent variable. Consequently, the growth of SMEs is operationalised as a process determined by the effects of taxation. Taxation variable determines the (a) cost of operation (b) and its effects on the nature of varying businesses. However, to respond to such adverse effects of taxation, SMEs have devised innovative data security measures to sustain their businesses (see Comparison of taxation effect on the growth of varying small and medium enterprises Growth Change  Sales  Profit  No. Employees  Capital Business security measures in line with tax avoidance on the growth of small and medium enterprises. The effect of taxation on the costs of operation of small and medium enterprises 52 Figure 2.1). The literature review revealed three independent variables that determine the growth of SMEs and thus the need to include them in the conceptual framework. The conceptual framework further relates the cost of operation as a crucial determinant to the growth of SMEs (McQueen and Thorley, 2001). Costs of operations are operationalized by analyzing and computing costs before and after taxation. The marginal increase in cost as a result of taxation may determine the rate of growth of SMEs. Arinaitwe (2006) asserts that tax elements heavily influence costs of operation, which is the cost per year of deploying capital in an investment project. Consequently, the effective return on capital is diminished to the extent of tax due on company income. Tax avoidance measures are useful in exploring the optimal legal procedures in response to the adverse effects of taxation. Within this framework, factors that determine the monetary cost of compliance, like the tax rate and penalty structure, drive tax compliance behavior (Allingham and Sandmo, 1972). In addition a rational taxpayer will avoid tax as long as the payoff from avoiding tax is greater than the expected cost of the process avoiding tax. Such processes include but not limited to taxpayer‘s incentive to purchase tax advisory services (Beck et al., 1996), 2) the effect of practitioners on tax avoidance (Klepper et al., 1991; Scotchmer, 1989), and 3) the effect of the tax administration (Scotchmer and Slemrod, 1989). Different types of SMEs will respond differently when subjected to the effect of taxation. The effect of taxation on varying nature of businesses can be operationalized by studying the effect of taxation on various types of businesses. The variable cost on each individual type of SMEs as a result of taxation will determine the rate of effect on the growth of such SMEs.