Inventory Items
Inventory Items are Invoicing specific, and are used to include default product descriptions, tax setting, cost and retail pricing for any freeform invoicing.
Timesheet Categories
Timesheet Categories are unique to Timesheets and are designed to be separate and customizable per project (via Project Settings). They're useful for reporting on the different types of work your team does. If you are looking to bill for time for each project, rates can be set against project members or against these timesheet categories to suit your business.
How do they work on an invoice?
When timesheets are added to an invoice, they will be added under the single 'Default Inventory Item for Timesheets' inventory item (configured via Settings > Invoice & Bill Settings).
Project Name, Timesheet Category, Timesheet User & Task Title all get combined into the Description area on the invoice.
So most companies that would like to invoice by time will have '1' Inventory Item, i.e., 'Timesheets' (already created by default), for which you can configure any default Tax rate setting as per your requirement.