CHOICE OF INVENTORY METHOD AND THE SELF-SELECTION BIAS

Abstract

We examine the sample self-selection and the use of LIFO or FIFO inventory method. For this purpose, we apply the Heckman-Lee’s two-stage regression to the 1973–1981 data, a period of relatively high inflation, during which the incentive to adopt the LIFO inventory valuation method was most pronounced. The predicted coefficients based on the reduced-form probit (inventory choice model) and the tax functions are used to derive predicted tax savings in the structured probit. Specifically, the predicted tax savings are computed by comparing the actual LIFO (FIFO) taxes vs. predicted FIFO (LIFO) taxes. Thereafter, we estimate the dollar amount of tax savings under different regimes. The two-stage approach enables us to address not only the managerial choice of the inventory method but also the tax effect of this decision. Previous studies do not jointly consider the inventory choice decision and the tax effect of that decision. Hence, the approach we use is a contribution to the literature. Our results show that self-selection bias is present in our sample of LIFO and FIFO firms and correcting for the self-selection bias shows that the LIFO firms, on average, had $282 million of tax savings, which explains why a large number of firms adopted the LIFO inventory method during the seventies.