The Much-Maligned Inventory Tax

When it comes to inventory taxes, five issues are readily identified.

First, they are complex.

Second, businesses that pay inventory taxes hate them.

Third, inventory taxes are unfair because they are nonneutral, and businesses that must maintain large inventories, such as manufacturers and retailers, are penalized by paying more in tax than businesses maintaining smaller inventories.

Fourth, local governments depend heavily upon revenue raised from inventory taxes in addition to other property taxes for school funding and other local needs, such as fire and police protection.

And fifth, whether imposed at the state or local level, competing political interests can make inventory taxes difficult to repeal.

Comparatively speaking, inventory taxation is not widespread. While business personal property is subject to tax in 38 states, inventory is included in only 14 of those states.

Some states, such as Kentucky, Mississippi, and West Virginia, tax inventory at the state level. In other states, like Alaska, Georgia, Louisiana, and Texas, inventory taxes are imposed and administered by local jurisdictions.

Unfortunately, that means that in some cases, a business that has located in an area where local jurisdictions overlap may have its inventory taxed twice. To further complicate matters, Texas has 250 property appraisal districts, each employing its own valuation factors.

However, in several states, many local jurisdictions encourage businesses to locate within their boundaries by offering “freeport exemptions.” For example, nearly all counties and 140 cities in Georgia have approved a Level One Freeport Exemption, which exempts 20, 40, 60, 80, or 100% of specified types of business inventory from tax, albeit with restrictions.

Although merchandise is not eligible for a Level One exemption, by referendum a local jurisdiction can approve a Level Two exemption, which includes merchandise.

Other states have a kind of hybrid structure. In Maryland, local jurisdictions impose the inventory tax, set rates, and so on. The state acts as a central collection agent.

Thus, for a business with inventory in three local jurisdictions, instead of reporting and filing forms with each jurisdiction, the business reports for the three jurisdictions on one form, which it then files with the state.

Massachusetts imposes a corporate excise tax on a corporation’s business personal property, including inventory. Other types of business entities — individuals, partnerships, associations, and trusts — are assessed and taxed locally.

In past years, Kentucky, Louisiana, and Texas have made attempts to alleviate the inventory tax burden on their business taxpayers.

Kentucky, which imposes an inventory tax at the state level, implemented an inventory tax credit mechanism that provides businesses with a nonrefundable and nontransferable credit of 100% of inventory taxes paid and can be applied to individual, corporate income, and limited liability entity taxes.

Louisiana, where inventory taxes are imposed and administered by local jurisdictions, implemented a tax credit mechanism in the 1990s that has undergone several iterations, mainly in response to the state’s fiscal woes in the mid-2010s.

As of today, the state allows a fully refundable credit of up to $500,000, with a carryforward period of 10 years. The downside, however, is that a business will lose any unused credit at the end of the carryforward period.

In 1997 Texas, where inventory taxes are also locally imposed and administered, allowed businesses a $500 credit for taxes paid. In 2022 that credit is still generously pegged at $500. By not accounting for inflation, the credit was worth $397 in 2019 dollars and is worth even less today.

Critics have long disparaged the inventory tax as damaging to a state’s business climate because it increases the cost of doing business and dampens profits.

Inventory taxes, it is claimed, put states at a competitive disadvantage. Businesses considering a move to a state with inventory taxes may choose to locate in a state without inventory taxes. Thus, critics conclude, the imposition of inventory taxes constrains a state’s economic expansion.

I spoke with Martin A. Sullivan, chief economist at Tax Analysts, and asked for his views on inventory taxes. He said there are three big issues to consider when thinking about inventory.

“Inventory is an investment,” Sullivan said, “that makes a firm more productive. It’s a productive asset.” A business with a lot of inventory can satisfy its customers more quickly and can handle supply disruptions much more readily, he said.

However, there are costs to a business that keeps a large inventory, such as storage, insurance, and financing costs, Sullivan explained, adding that a business with too much or too little inventory may be guilty of bad inventory management, but having inventory by itself is not a negative.

Second, he continued, “are the tax consequences of handling inventory, whether the business uses the [first-in, first-out] or [last-in, first out] methods.”

A business that uses FIFO will realize more profit, but, in turn, will pay more in taxes, Sullivan said. Using the LIFO method means a business will make less profit but will realize greater tax savings, he explained, adding that inflation has a large impact on which method a business uses: In periods of rising prices, it makes more sense from a tax standpoint for a business to use the LIFO method, and vice versa when inflation is low. However, even in periods of high inflation, Sullivan said, there is a benefit to using FIFO “because it reduces the tax penalty.”

Third, he said, “The inventory tax is very old-fashioned, from our manufacturing past. [Inventory] was taxed because you could see it and get an idea of the size of the company. [But] there’s no reason to tax inventory [today]. A business that must carry a large inventory might decide not to locate in a state that has an inventory tax. But if the business is large enough and promises to provide a significant number of jobs, it might negotiate with the state a waiver of inventory tax as an economic development initiative. It’s unfair to the business that’s been in the state for 20 years and is paying inventory tax. Having an inventory tax makes for a bad business climate, and if the incoming business gets a waiver, it creates tension with the businesses that were already there.”

Sullivan further pointed out that having enough inventory becomes more important when there are supply disruptions: “If businesses could keep more inventory without tax consequences, we would have less supply disruptions.”

As for the states, he said, an inventory tax is “a dumb tax. It’s inefficient. On top of that, if states are giving special breaks, it’s unfair.”

Given the inventory tax’s unpopularity among businesses and its detrimental effect on a state’s business climate, state legislatures often attempt to repeal the tax. It’s not easy, however.

This year, the West Virginia State Legislature, which in the past has tried to repeal its inventory tax without success, is trying again. The initiative will be on the ballot for the November elections. The initiative is expected to improve West Virginia’s business climate, in hopes that businesses will locate there and bring more jobs to the state.

State Sen. Chandler Swope (R), who has long advocated for repealing the inventory and other property taxes, said, “Last year, we thought cutting the personal income tax would have a higher rate of return on investment, but it turns out these taxes would,” adding that “hundreds of companies cancel West Virginia out because of these taxes.”

Chandler believes that the lost revenue will be replaced as businesses and people move into the state. Local governments are not so sanguine. County assessors pointed out that real estate taxes would have to be doubled to make up for the lost revenue, but Chandler assured that isn’t the case because the state will backfill that revenue.

As for the repeal effort, he said the problem “is that counties and school boards don’t trust the legislature to replace the money.” That’s a good point, especially since, according to Chandler, “The counties and the assessor’s association was told by the tax department, ‘Oh, you won’t get the money back.’”

Still, Chandler says West Virginia has the money to make local jurisdictions whole because the state has enjoyed an organic expansion for the past three years and repealing property taxes will only enhance its economic climate.

County officials have said the proposal is a good one — in theory. Their concern is how the revenue will be made up on a long-term basis.

Aside from the revenue issue, other groups have pointed out that repealing the inventory and other property taxes that local governments rely on represents a “significant shift in power away from local governments to the state government.”

From these and other comments, it looks like Chandler and other supporters of the repeal are going to have a hard fight on their hands.

Conclusion

Inventory taxes, whether imposed at the state or local level, are complicated and much maligned by businesses. They’ve been criticized as detrimental to a state’s business climate and stifling to economic growth. Yet local governments are heavily dependent on them to provide the services needed by businesses and residents alike.

However, states and local jurisdictions have recognized the tax burden carried by businesses and have taken steps to lighten the load by offering credits and special exemptions. That’s good.

The problem is these credits and special exemptions don’t fall evenly on all businesses in states that have the inventory tax, which helps to explain the many failed efforts over past decades to eliminate the tax.

In 2022 one state is tilting at the inventory tax yet again. For them, this time just might be the charm.