Kenya’s Fiscal Deficit Set to Surge 10.23% as Government Increases Domestic Borrowing Strategy

Kenya’s fiscal deficit is projected to widen by 10.23 percent in the 2026/27 financial year (FY), signaling renewed pressure on the country’s borrowing plans despite ongoing fiscal consolidation efforts by the government. This expansion in the deficit raises critical questions about the sustainability of Kenya’s public finances and the effectiveness of current fiscal policies aimed at reducing the country’s debt burden.

According to the 2025 Budget Review and Outlook Paper (BROP) released by the National Treasury, the fiscal deficit will rise to Sh1.017 trillion, equivalent to 4.9 percent of GDP, compared to Sh923 billion in the 2025/26 fiscal year. This represents a significant increase that could have far-reaching implications for Kenya’s economic stability and creditworthiness in international markets.

“The 2026/27 fiscal deficit is set at Sh1,017.6 billion, equivalent to 4.9 percent of GDP,” the Treasury stated in the BROP document. “This represents a 10.23 percent increase in the size of the deficit compared to 2025/26.”

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Domestic Borrowing Strategy Takes Center Stage

The National Treasury plans to finance this substantial gap through a carefully calibrated mix of domestic and external borrowing, with a marked strategic tilt toward the local market. This shift reflects both global financial constraints and a deliberate policy choice to reduce exposure to foreign currency risks and external debt vulnerabilities that have historically plagued Kenya’s public finances.

Domestic financing will rise significantly to Sh775.8 billion, up 22.07 percent from the current fiscal year’s allocation, while external financing will stand at Sh241.8 billion. This breakdown highlights the government’s growing reliance on local borrowing amid tight global financial conditions, limited access to concessional funding from multilateral development banks, and rising interest rates in international capital markets that make foreign borrowing increasingly expensive.

The shift toward domestic borrowing represents approximately 76 percent of total deficit financing, a proportion that has steadily increased over recent years as Kenya has sought to restructure its debt portfolio. However, economists and financial analysts have raised concerns that this increased domestic uptake could heighten competition for credit with the private sector, potentially pushing up interest rates across the economy and creating what is known as “crowding out” – where government borrowing absorbs available credit that would otherwise flow to businesses and entrepreneurs.

Implications for Private Sector Growth

The crowding out effect could have serious implications for Kenya’s economic recovery and growth trajectory. When government borrowing drives up interest rates, private businesses face higher costs of capital, which can discourage investment in productive activities, expansion plans, and job creation. Small and medium enterprises (SMEs), which are particularly sensitive to interest rate changes and form the backbone of Kenya’s economy, could be disproportionately affected by this dynamic.

Commercial banks, which hold the majority of government securities, may find treasury bills and bonds increasingly attractive compared to lending to businesses, especially given the perceived risk-free nature of government debt. This preference could further constrain credit availability to the private sector, potentially slowing economic activity in key sectors such as manufacturing, agriculture, and services.

Yet, the Treasury maintains that the move aligns with its medium-term debt management strategy aimed at balancing cost and risk while sustaining economic recovery. Treasury officials argue that domestic borrowing reduces foreign exchange risk, extends debt maturity profiles, and builds domestic capital markets – all of which are important objectives for a developing economy like Kenya.

Revenue Challenges Persist Despite Reform Efforts

The fiscal expansion comes at a particularly challenging time when Kenya continues to face persistent revenue shortfalls, despite the implementation of new tax measures and expenditure rationalization initiatives undertaken by the government. The country’s tax-to-GDP ratio remains below the sub-Saharan African average and far below levels seen in more developed economies, indicating substantial room for improvement in revenue collection efficiency.

Total expenditure for the 2026/27 FY is projected at Sh4.65 trillion, against projected revenues of only Sh3.58 trillion, leaving a substantial financing gap of over Sh1 trillion that will again test the government’s debt sustainability targets and commitments made to international financial institutions such as the International Monetary Fund (IMF).

This revenue-expenditure gap reflects the fundamental fiscal challenge facing Kenya: the government’s spending commitments – driven by development needs, recurrent obligations, and debt servicing costs – continue to outpace its ability to generate revenue. Despite efforts to expand the tax base, improve compliance, and introduce new revenue measures, collections have consistently fallen short of projections in recent years.

Understanding Kenya’s Fiscal Pressures

To understand the current fiscal situation, it’s important to examine the various pressures driving both expenditure growth and revenue constraints. On the expenditure side, Kenya faces multiple competing demands including infrastructure development, healthcare expansion, education funding, security spending, and the ever-growing burden of debt servicing costs.

Debt servicing has become one of the largest and fastest-growing components of government spending. In recent years, Kenya has seen debt service costs consume an increasing share of revenue, leaving less fiscal space for development and social spending. The 2026/27 projections suggest this trend will continue, with a significant portion of the Sh4.65 trillion budget allocated to meeting interest payments and principal repayments on existing debt.

Infrastructure development remains a priority for the Kenyan government as it seeks to close the infrastructure gap and support economic growth. Major projects in transport, energy, and digital infrastructure require substantial capital investments. While such investments can yield long-term economic returns, they create immediate fiscal pressures, particularly when financed through borrowing rather than revenue.

The Revenue Collection Challenge

On the revenue side, Kenya faces multiple obstacles to achieving its collection targets. The informal sector, which accounts for a substantial portion of economic activity, remains largely outside the tax net. Tax evasion and avoidance, facilitated by weak enforcement mechanisms and limited technological capacity, continue to erode the revenue base. Additionally, numerous tax exemptions and incentives, while sometimes justified for policy reasons, reduce potential collections.

The Kenya Revenue Authority (KRA) has implemented various reforms aimed at improving tax administration, including digitalization initiatives, enhanced taxpayer services, and stricter enforcement measures. However, progress has been uneven, and collections continue to fall short of increasingly ambitious targets set by the Treasury.

Economic headwinds also affect revenue performance. Slower-than-expected economic growth reduces income and consumption tax revenues. Volatility in commodity prices impacts customs duties and indirect taxes. Currency fluctuations affect the shilling value of foreign currency-denominated tax payments. All these factors contribute to the persistent gap between projected and actual revenues.

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International Context and Regional Comparisons

Kenya’s fiscal challenges must be understood within the broader regional and international context. Many African countries face similar pressures, including high debt burdens, limited fiscal space, and the need to balance development spending with fiscal prudence. However, Kenya’s situation is complicated by its relatively high debt-to-GDP ratio compared to regional peers and its exposure to both domestic and external financing risks.

The East African Community (EAC) has established fiscal convergence criteria that member states are expected to meet, including targets for budget deficits and debt levels. Kenya’s projected deficit of 4.9 percent of GDP exceeds the EAC’s recommended ceiling of 3 percent, potentially creating tensions with regional integration objectives and limiting policy coordination within the bloc.

International financial institutions, particularly the IMF, closely monitor Kenya’s fiscal performance through various lending programs and surveillance activities. Kenya currently operates under an IMF program that includes fiscal consolidation targets and structural reform commitments. The widening deficit projected for 2026/27 may complicate Kenya’s relationship with the IMF and could trigger discussions about program modifications or additional conditionalities.

Debt Sustainability Concerns

The projected increase in borrowing raises important questions about debt sustainability – the government’s ability to service its debt obligations without requiring debt restructuring or significantly impairing economic growth. Kenya’s public debt has grown rapidly over the past decade, driven by infrastructure investments, budget deficits, and in some cases, weak expenditure controls.

As of the most recent data, Kenya’s public debt stands at approximately 70 percent of GDP, approaching levels that some economists consider problematic for developing countries. While this ratio remains below the critical 100 percent threshold, the trajectory is concerning, particularly given Kenya’s moderate economic growth rates and persistent revenue challenges.

Debt sustainability assessments consider not just the current debt stock but also debt service obligations, contingent liabilities, and the government’s capacity to generate primary surpluses (revenue minus non-interest expenditure). On these metrics, Kenya faces challenges. Debt service is absorbing an increasing share of revenue, limiting fiscal flexibility and crowding out other priority spending areas.

The Political Economy of Fiscal Policy

Understanding Kenya’s fiscal trajectory also requires attention to political economy factors. Fiscal policy doesn’t occur in a vacuum but reflects political pressures, competing interests, and governance dynamics. In Kenya, several political economy factors influence fiscal outcomes.

Electoral cycles create pressure for increased spending, particularly on visible projects and programs that can generate political support. While the next general election is scheduled for 2027, preparatory activities and positioning begin well in advance, potentially affecting fiscal discipline as political actors seek to demonstrate responsiveness to constituents’ needs.

Devolution, introduced by Kenya’s 2010 Constitution, has transformed the country’s fiscal landscape by creating 47 county governments with constitutionally guaranteed revenue shares and spending responsibilities. While devolution has brought government closer to citizens and enabled more localized development, it has also complicated fiscal management, created additional coordination challenges, and sometimes contributed to fiscal pressures at both national and county levels.

Sectoral Spending Priorities

The Sh4.65 trillion projected expenditure for 2026/27 will be allocated across various sectors, each with distinct needs and constituencies. Education consistently receives one of the largest allocations, reflecting the government’s commitment to universal primary and secondary education and expanding access to higher education. However, quality concerns persist despite increased spending.

Healthcare spending has received renewed attention following the COVID-19 pandemic, which exposed weaknesses in Kenya’s health system. The government has committed to expanding universal health coverage and strengthening health infrastructure, but financing remains a challenge given competing priorities and resource constraints.

Infrastructure continues to absorb substantial resources, with ongoing projects in roads, railways, ports, and energy requiring completion funding while new projects are launched to address remaining gaps. The economic returns to infrastructure investment can be substantial, but they typically materialize over long time horizons, creating a mismatch with immediate fiscal costs.

Security spending has increased in response to terrorism threats, particularly from Al-Shabaab in Somalia, and domestic security challenges. Maintaining internal security and defending borders require substantial resources, limiting funds available for development and social spending.

Reform Priorities and Potential Solutions

Addressing Kenya’s fiscal challenges requires a comprehensive approach targeting both revenue enhancement and expenditure efficiency. On the revenue side, priorities include broadening the tax base by bringing more of the informal sector into the tax net, improving tax administration through continued digitalization and enhanced enforcement, rationalizing tax exemptions and incentives that provide limited economic benefits, and potentially introducing new revenue sources.

Property taxation represents a largely untapped revenue source in Kenya. Despite substantial property wealth, particularly in urban areas, property taxes contribute minimally to government revenue due to weak valuation systems, limited enforcement, and political sensitivities. Strengthening property taxation could provide significant additional revenues while also improving equity in the tax system.

Digital taxation has emerged as a potential revenue frontier. As Kenya’s digital economy grows, ensuring that digital transactions and platforms contribute appropriately to tax revenue becomes increasingly important. However, designing and implementing digital taxes requires careful consideration to avoid stifling innovation and growth in this dynamic sector.

On the expenditure side, efficiency improvements could generate fiscal space without reducing service delivery. Many government programs suffer from inefficiencies, duplication, and weak implementation that reduces their effectiveness. Strengthening public financial management systems, improving project selection and execution, and eliminating wasteful spending could make each shilling of government spending more productive.

Subsidy rationalization represents another potential area for fiscal savings. Kenya maintains various subsidies, some of which are poorly targeted and benefit non-intended recipients. Reforming subsidy programs to better target vulnerable populations while reducing overall fiscal costs could improve both equity and efficiency.

The Path Forward

As Kenya navigates toward the 2026/27 fiscal year with a projected deficit of Sh1.017 trillion, policymakers face difficult choices. Maintaining fiscal discipline while meeting development needs requires careful prioritization, improved efficiency, and potentially difficult political decisions about taxation and spending.

The increased reliance on domestic borrowing, while reducing some external risks, creates its own challenges through potential crowding out of private investment and rising interest costs. Balancing these competing considerations will test the government’s economic management capabilities and political will to implement necessary but sometimes unpopular reforms.

International support and cooperation will remain important. Kenya benefits from relationships with multilateral institutions, bilateral partners, and regional organizations that provide both financial resources and technical assistance. Maintaining these relationships while preserving policy autonomy requires skillful diplomacy and demonstrated commitment to fiscal prudence and reform.

Ultimately, Kenya’s fiscal trajectory will be determined by its ability to accelerate economic growth, which provides the foundation for sustainable revenue increases; improve revenue collection efficiency; enhance expenditure quality and targeting; manage its debt burden prudently; and maintain political stability and sound governance that support economic activity and investor confidence.

The 10.23 percent increase in the fiscal deficit for 2026/27 represents both a challenge and an opportunity. The challenge lies in financing this deficit without creating unsustainable debt dynamics or crowding out private sector growth. The opportunity lies in using this fiscal space to make strategic investments and undertake reforms that can accelerate growth and transform Kenya’s economic trajectory. How effectively Kenya navigates these competing pressures will shape its economic prospects for years to come.

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By: Montel Kamau

Serrari Financial Analyst

22nd October, 2025