TAX TREATMENTS OF INVENTORY AND THEIR REAL EFFECTS: THEORY AND EVIDENCE

This thesis examines the real effect of the tax treatment of inventory on a firm's production.; Taxation of nominal rather than real gains creates a serious distortion of a firm's optimal behavior in inflationary periods. A choice of inventory valuation methods makes a significant difference in a firm's cash flow resulting from a difference in taxable income.; Under the LIFO (Last-In, First-Out) method, nominal gains on inventory holdings are indexed for inflation since the last goods produced are assumed to be the first sold. However, under the FIFO (First-In, First-Out) method, inflation creates nominal gains on inventory holdings since the first goods produced are assumed to be the first sold. Thus, in inflationary periods, the cost of goods sold is greater under LIFO than FIFO because the units of inventory sold are valued at higher, more recent prices under LIFO. Hence the LIFO method generates smaller taxable income than FIFO.; I develop a theoretical model encompassing accounting concepts associated with taxation and the stock-out inventory model of economics. The theoretical analysis demonstrates that firms switching to LIFO produce more than they would otherwise during inflationary periods.; To examine empirically the findings of the theoretical analysis, a cross-section study at the firm level is conducted. This study uses the Compustat Industrial Annual Data File. The two stage estimation method suggested by Heckman (1976) and Lee (1976) is used to estimate the switching regression model.; The first stage is a binary probit estimation of the reduced form decision equation for the choice of inventory valuation method. The second is an OLS estimation of the two production equations for LIFO and FIFO. In the second stage OLS equations, the signs of the estimated coefficients of the Mills ratios imply that the observed production levels of the LIFO firms show greater production levels than planned due to the choice of LIFO. The estimation results support the findings of the theoretical analysis.