Inventory Control under Corporate Income Tax and Accrual Accounting

Abstract

Corporate income tax (CIT), as an important economic instrument in most jurisdictions, constitutes a significant portion of financial costs in business operations. It is known that the structure of tax function, accounting method and loss carryover policy have significant impacts on a firm's operational strategies, which, however, has received little attention in operations management literature. In this paper, we study the effects of taxation on optimal inventory policies under accrual accounting. More specifically, we consider a risk-neutral firm managing a single-item periodic-review inventory system. We formulate the problem as a cyclic stochastic dynamic program with multiple accounting periods, each of which consists of multiple ordering periods. We first show that the optimal inventory policy can be characterized by an income-dependent base-stock policy in both the setting with proportional tax and loss carryforward and the setting with general progressive tax and no loss carryforward. We show that tax function convexity and loss carryforward may introduce conflicting incentives into the decision making: the formal drives risk-averse decision while the latter induces risk-seeking behavior. In particular, we further identify two intertemporal effects of taxation, namely, the intra-accounting-period effect and the inter-accounting-period effect, on optimal inventory decisions, both inducing smaller basestock levels due to the tax function convexity. Our numerical study further examines the effects of various characteristics of taxation on the optimal policies and shows that ignoring taxation in inventory decisions may result in significant losses when the degree of tax function convexity and demand uncertainty are sufficiently high, which reinforces the value of tax considerations in inventory management.

Keywords: Inventory management; corporate income tax (CIT); accrual accounting; stochastic dynamic programming