Effects of tax instruments on the profitability of manufacturing Small and Medium Enterprises in Nairobi County, Kenya

Abstract

The manufacturing sector plays a critical role in Kenya’s economic development, accounting for an estimated 15–20 percent of the SME base and contributing approximately 7.6 percent to national GDP and employment in 2024. Despite its importance, the profitability of manufacturing SMEs remains constrained, with taxation emerging as a key impediment. This study examined the effect of tax instrument on the profitability of manufacturing SMEs in Nairobi County, Kenya, focusing on Value Added Tax (VAT), income tax, excise tax, and tax compliance costs across key subsectors. The study was anchored on the Ability-to-Pay Theory and the Benefit Theory of taxation. Using secondary panel data obtained from Kenya Revenue Authority for 224 SMEs over the period 2019–2024, the study applied descriptive statistics, correlation analysis, diagnostic tests, and Random Effects Generalized Least Squares (GLS) regression. The findings revealed notable sectoral disparities in both profitability and tax instrument. Capital-intensive and highly regulated sectors such as motor vehicle assembly, petroleum and lubricants, and tobacco products recorded higher profitability but also experienced significantly stronger negative effects of taxation. In contrast, relatively smaller sectors such as plastic packaging, cosmetics, and confectionery exhibited lower profitability and comparatively weaker tax effects. Across all sectors, VAT, income tax, excise tax, and compliance costs had negative and statistically significant impacts on SME profitability. Income tax emerged as the most influential constraint, particularly in high-revenue sectors, while VAT and excise taxes increased production costs and reduced liquidity. Compliance costs further compounded these effects by imposing administrative burdens. Overall, taxation variables explained approximately 50 percent of the variation in SME profitability, with stronger explanatory power observed in highly regulated subsectors. The study concludes that Kenya’s tax structure imposes uneven but significant constraints across manufacturing industries. It recommends sector-sensitive tax reforms, including streamlined VAT processes, progressive income tax structures, rationalized excise duties, and reduced compliance costs, to enhance SME profitability, competitiveness, and sustainability.

Key Words: Tax compliance, Value Added Tax, Income tax, Excise tax, Compliance cost, profitability of Manufacturing SMEs