Smart ways to protect markets when tax incentives backfire

In 1902, French colonial officials in Hanoi, Vietnam, launched a clever-sounding plan to fight a rat infestation: they offered a bounty for every rat tail turned in.

At first, the results looked promising—thousands of tails were delivered. But then, the authorities noticed something odd: rats were still scurrying through the sewers—without tails.

It turned out people were cutting off rat tails and releasing the rats, allowing them to survive and reproduce. Others began breeding rats just to claim the bounty.

What began as a sanitation measure quickly became a perverse incentive scheme that increased the rat population instead of reducing it.

This episode, now immortalised as the “Hanoi rat bounty fiasco,” remains one of history’s clearest examples of well-intended incentives gone spectacularly wrong. But it’s not just history. The same logic failure has quietly played out in Kenya in recent years—this time, not with rats, but with alcohol.

Governments routinely use tax incentives to support specific groups—whether to boost morale, promote welfare, or ease service delivery.

These incentives, while well-meaning, result in what economists call tax expenditures—a form of public spending that occurs before revenue is even collected. Though common, tax expenditures can carry far-reaching effects, especially when applied to high-value and high-tax goods.

Kenya has quietly experienced this. A policy to supply reduced-cost alcohol to closed institutional groups—likely well-intended—produced unintended market spillovers.

By 2020, reports indicated that subsidised goods were being resold into commercial markets, undercutting legitimate traders burdened by full tax and compliance obligations. Local producers, wary of pricing pressures and brand dilution, scaled back. Imports picked up the slack.

By 2022, Treasury estimates reported in this publication (September 2023) showed that tax expenditures from the programme had reached nearly Sh3 billion annually.

But the greater cost may lie beneath the surface: the resale premium—the price gap between subsidised and taxed alcohol—created a powerful arbitrage opportunity. A secondary, informal market emerged. The policy intended to provide internal support had unintentionally commercialised a tax break.

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Recent findings go even further. A study by Euromonitor International, reported in this publication (April 2024), estimates that illicit alcohol now accounts for over 60 percent of all alcohol sold in Kenya, resulting in an estimated Sh71 billion in annual tax losses.

This isn't solely the result of smuggling or counterfeiting—it's also a reflection of how policy design can unintentionally reinforce the informal economy when resale incentives exist.

Incentive trap

This is classic incentive misalignment: when a good carries resale value well above its subsidised price, the incentive shifts from consumption to redistribution. In high-tax sectors like alcohol and tobacco, where taxes can make up half the retail price, the temptation to divert is built in.

And Kenya is far from alone. In Iraq, fuel subsidies meant to support domestic industry were diverted and sold abroad, creating a billion-dollar smuggling economy. In Australia, steep tobacco taxes gave rise to an illicit market in untaxed and counterfeit cigarettes.

In both cases, the market wasn’t disobeying policy—it was responding to the incentives the policy created.

The issue is further complicated by regional tax structures. The East African Community (EAC) has harmonised its Common External Tariff (CET), but domestic excise taxes remain misaligned. This results in the same product—like alcohol—carrying significantly different tax burdens across borders. That difference creates a cross-border resale premium, ripe for exploitation by informal trade networks.

Layered onto domestic price incentives, the effect multiplies. Kenya ends up with two alcohol markets: One formal, regulated, and taxed.

The other informal, subsidised, and increasingly attractive to counterfeiters and smugglers. Enforcement, while critical, is left chasing symptoms of a deeper structural distortion.

Rethinking the instrument

As Kenya’s budgeting cycle reaches its peak, this is the moment to rethink the choice of fiscal instruments. Every tax break is a form of silent expenditure—a leakage that happens before revenue is even booked.

When that break is applied to a tradable, high-tax product, the risk of market distortion becomes inevitable.

The core policy question is this: Should support be delivered through a tax break—or a direct transfer?

Whereas tax breaks create resale incentives, income-based transfers preserve the intent without disrupting pricing. They are transparent, auditable and targeted. In environments where enforcement is difficult and markets are fluid, transfers serve better. This isn’t about reducing support—it’s about delivering it smarter.

Goods like alcohol and fuel—easy to repackage, easy to resell—should not be the vehicle for support. Instead, targeted allowances—whether for hardship, morale, or service conditions—can achieve the same ends without triggering informal markets.

Because when incentives are delivered through price gaps, they fuel arbitrage. But when delivered through income, they reinforce fiscal equity and market order.

As Kenya escalates its efforts to combat illicit trade, counterfeit goods, and tax leakage, it’s time to look beyond enforcement—and turn to design.

The same way Hanoi’s rat bounty taught the French that not all incentives are harmless, our own experience with alcohol tax breaks must teach us that not all support is neutral.

A well-designed incentive strengthens the beneficiary and the system, while a poorly designed one, builds a second economy in its shadow.

The writer is a macroeconomist and researcher at the Kenya Revenue Authority. [email protected]