The Tax Break-Down: LIFO Accounting
This is the second post in a new CRFB blog series The Tax Break-Down, which discusses tax breaks under discussion as part of tax reform.
Last-in, first-out accounting, or LIFO, is a preferential method of measuring profits from inventory sales and is one of the ten largest tax breaks in the corporate code. LIFO accounting has been part of the U.S. tax code since 1939, but it is a uniquely American invention; it is not permitted under International Financial Reporting Standards.
To determine taxable profit, a company must subtract costs from gross revenues. LIFO accounting allows companies to sell inventory and calculate the purchase cost of that inventory -- which determines the deduction they may take -- as if the most recent product sold was the most recent bought and stored as inventory.
By contrast, for normal accounting, most companies use first-in, first-out (FIFO) accounting, which assumes that the item sitting on the shelf for the longest is sold first. Since prices tend to rise over time, being able to sell the last product first often allows companies to claim they paid the highest price and therefore achieved the lowest amount of profit for tax purposes.
For many retail industries, where goods are bought and sold quickly, there is little difference between the accounting methods. However, in industries where inventories move slowly and prices change quickly (like industrial equipment or petroleum), the difference can be significant. This difference is most pronounced for companies that bought their first inventories decades ago.
To take an extreme example, assume a company purchased a barrel of oil for $1 in 1939, when LIFO was first adopted, and then purchased an additional barrel each year with the hopes of selling that oil starting in 2013. Under standard accounting "FIFO" rules, the first barrel of oil the company sold would generate about $100 of revenue at a $1 cost, leaving a $99 taxable profit. By comparison, LIFO rules would allow the company to subtract last year’s cost of about $90 and pay taxes on only $10 of profit – allowing a 90 percent reduction in the company’s tax burden.
Though the above example rarely occurs so starkly, many companies keep some inventory indefinitely, leading to a permanent deferral of some of their tax liability.
Below, we answer other questions about LIFO accounting rules.
How Much Does It Cost?
According to Joint Committee on Taxation, the cost of the LIFO tax break is about $5 billion in 2013, which we estimate at $60 to $65 billion over a decade. Most (85 to 90 percent) of the value of LIFO accrues to C-Corporations paying the corporate income tax, while the remainder accrues to pass-through entities which pay through the individual tax. Another related tax expenditure called lower-of-cost-or-market (LCM), which allows companies to deduct losses if inventory costs at market prices are below the purchase price, costs an additional $8 billion or so over a decade.
Because the transition from LIFO to FIFO would lead to the reclassification of current inventory, the revenue raised from repealing LIFO would be more than the value of the tax expenditure in the short run. According to our Corporate Tax Calculator, repealing LIFO on its own would raise enough revenue over ten years to reduce the corporate tax rate by 0.6 percentage points. Importantly, the corresponding rate reduction would be much less significant over the long-run.
Who Does It Affect?
LIFO is used primarily by a select group of companies who have had time to accumulate old inventories. A "LIFO reserve" is the cumulative total of the profit difference between using LIFO and if the company had been using FIFO in that year. It does not represent available cash, but the amount that past profits would be higher under a different accounting system. According to CFO Magazine, energy companies hold over one-third of LIFO reserves, and manufacturers about one-sixth. This chart only measures publicly traded companies ranked by Moody’s, as only publicly traded companies must disclose their LIFO reserve.
|Inventory and LIFO Reserve by Industry (millions)|
|Industry||Inventory||LIFO Reserve||Percent of Total|
|Metals and Mining||$8,876||$4,100||10%|
Source: Moody's Investors Service
What are the Arguments For and Against LIFO?
Repeal proponents argue that LIFO has no value as an accounting system and is only used to reduce tax liability. Put even more bluntly, critics have described LIFO as a "massive tax holiday for a select group of taxpayers." Repeal would end a system where taxpayers can permanently defer taxes on gains from rising prices. In addition, they argue that LIFO encourages an economically inefficient accumulation of inventory. In their view, LIFO is "the equivalent of a deduction for a cost that is never incurred" because of the tax deferral it represents.
Proponents of retaining LIFO, on the other hand, argue that LIFO encourages economically-valuable inventory investment and keeps inventory on comparable footing with other investments like machinery and buildings that benefit from accelerated depreciation. LIFO proponents also argue that LIFO accounting offsets what would otherwise be a tax on inflation, since inventory value may increase simply because prices do. Finally, they argue that repealing LIFO would mean taxing past decisions – as far back as 70 years ago – and claim "the extent of this retroactive reach by the government appears to be unprecedented in the history of the Internal Revenue Code."
What are the Options for Reform and What Plans Have Other Plans Done?
Most comprehensive tax reform plans would repeal LIFO accounting, including the President’s Business Tax Reform Framework, the Simpson-Bowles tax reform plan, the Domenici-Rivlin tax reform plan, and even the 2007 tax reform bill introduced by Charlie Rangel. The Wyden-Gregg bill from 2010 does not repeal LIFO, though it does propose a one-time adjustment for large oil companies which reduces the benefit of LIFO by re-valuing their inventory.
When it comes to repealing LIFO, however, there are a number of questions which have to be answered. For example, what accounting mechanism is it replaced with? And is the repeal accompanied with a repeal of lower-of-cost-or-market rules?
Furthermore, immediately repealing LIFO and replacing it with FIFO would cause companies to claim large one-time profits from their historic inventories, which would be a massive one-time tax increase. Most proposals to repeal LIFO would space out back taxes over a number of years. As a result, revenue estimates will vary based on reform plan – though they will always be substantially larger over the first decade than over the long-run. For instance, CBO estimates that repealing LIFO and spreading the profits over 4 years will raise about $100 billion over that per, but only
|Parameters and Revenue from Different LIFO Options|
|Re-valuate LIFO inventories for large integrated oil companies; repeal LCM||$12 billion (2011-2020)||Wyden-Gregg|
|Replace LIFO and lower-of-cost-or-market (LCM) with FIFO or specific identification method, phased in over 4 years||$112 billion (2014-2023)||CBO Budget Option|
|Replace LIFO with FIFO, phased in over 10 years||$78 billion (2014-2023)||President's Budget|
|Replace LIFO with FIFO, phased in over 8 years||$107 billion (2008-2017)||Rangel Bill (HR 3970)|
|Repeal lower-of-cost-or-market (LCM) method, phased in over 4 years||$5 billion (2014-2023)||President's Budget|
Where Can I Read More?
- Internal Revenue Service – FIFO/LIFO
- Tax Policy Center – 2011 Budget Tax Proposals (Repeal LIFO)
- Kleinbard, Plesko & Goodman – Is It Time to Liquidate LIFO?
- Alan Viard – Why LIFO Repeal Is Not the Way to Go
- Sherry Slater, The Journal Gazette – Is LIFO As We Know Over?
- Scott Gibson – LIFO vs. FIFO: A Return to the Basics (Oldies, Still Goodies)
- Dopuch & Pincus – Evidence on the Choice of Inventory Accounting Methods: LIFO Versus FIFO
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Repealing LIFO for inventory accounting would bring the United States in line with international accounting standards while eliminating a major source of tax deferral for businesses. At the same time, LIFO can adjust for gains due solely to inflation and maintain tax neutrality between inventory and other types of capital. With that said, retaining LIFO would take a sizeable amount of revenue off the table, even if more of that revenue is one-time, upfront revenue rather than a long-term permanent gain. But dealing with LIFO isn't just a matter of repeal or retain--policymakers must decide which accounting method works best to determine how inventory is counted in a business's taxable income.
Click here to read more entries in The Tax Break-Down.