I wish that everyone who weighs in on this thread would specify the bitrate and compression scheme they're using. I've been less "scientific" about this, but very frequently switching setups and listening critically.
I have many headphones, including Grado SR80's, an ancient Stax electrostatic rig w/ amp, and Etymotic 4p's. My current headphone amp is an upscale railsplitter CMoy, so I'll have better insights into this when I build my PIMETAs.
I've always considered the general acceptance of 128 kbps audio a ghastly phenomenon that will pass like the dot matrix printer era I lived through. Print was better before, and is better now. Sound was better before, and will be better when we move back to CD-quality audio, will be much better when we move to 24 bits.
My oldest rips are 320 kbps MP3's. More recently I rip to Apple Lossless and reprocess to 320 kbps AAC's, saving both. I'm glad I did. With everything before my Etymotic earphones, I mildly preferred lossless to AAC to MP3, but not enough to rerip my MP3's or give up capacity on my iPod to carry only lossless.
With my Etymotic 4p's, I hear what's on the CD, for better or worse. There is often magic in good recordings. That magic disappears if I do any single thing wrong, such as: Have the arrogance to solder a 4p to 4s converter using RadioShack grade resistors. Use a perhaps defective SendStation PocketDock for my line out, rather than an Apple Dock. Use AAC or MP3 rather than Apple Lossless. So now I only carry around lossless. I swap music onto my iPod the way I used to swap CD's into my car.
I'm pretty far down the food chain in gonzo high-end audio, but we've all heard this "weakest link" theory before, and we all know it's true. Your sound is probably limited by your headphones, or your connectors. It's certainly limited by the source recording. If you're using lossy data compression, it's certainly limited by the compression.
To reach the question under debate, using Etymotic 4p earphones and Apple Lossless compression, I hear magic through line out that is somewhat missing through headphone out. Using other headphones and lossy compression, I can't hear a difference, when I set the headphone volume somewhat shy of max. (I settled naturally on this, agreeing with what several of you assert.)
In other words, I think there's no debate here, every one of you is right.