Beyond Marginal Tax Rates: LIFO

While much of the nation's tax debate centers on marginal income tax rates, a slew of deductions, incentives, loopholes, and accounting tricks escapes the attention of media and the electorate at large.  These lesser known tax issues can amount to huge tax breaks for their recipients--sometimes by design, but sometimes not.  In an effort to further understanding of the tax system in place, I will periodically be posting on these lesser known issues and what they mean for American tax policy.

If you've never heard the term LIFO, you are not alone.  LIFO is the acronym for "Last In, First Out," which is simply an accounting method for valuing inventory, and the term is typically reserved for some of the most technical accounting discussions that can take place in a business environment.  However, LIFO means big money for some of America's largest corporations.  Here's how it works:

Imagine that you are a large oil company.  Every year, you must prepare financial statements and file a tax return like any other company.  One of the largest expenses your company will incur is "cost of goods sold."  Calculating the cost of goods sold can be complicated though.  As a large oil company, you maintain a large reserve of oil as a course of business.  Additionally, you continue to purchase oil throughout the year.  You encounter a problem when you must calculate the cost of goods sold because your reserves and the oil you purchased throughout the year were purchased at varying prices.  It is impossible to determine exactly  the cost of the specific oil that was sold throughout the year, as the oil mixes together in the reserves tanks and is completely homogenous.  In order to solve this problem, accountants developed a number of ways to account for the cost of goods sold.  The two most important methods are LIFO and FIFO.

As earlier stated, LIFO stands for "Last In, First Out."  This means that the latest purchase of goods is treated as the first item sold when calculating the cost of goods sold.  FIFO stands for "First In, First Out," and it means that the earliest purchase of goods is treated as the first item sold when calculating the cost of goods sold.  You must chose one of these methods.  Is there an advantage to either method?

The answer is a resounding "yes."  Because a normal economy experiences incremental inflation, LIFO presents a clearly superior option for companies with large inventory reserves.  Consider an oil company that has been around for 40 years.  The price of oil in 1971 was around $18/barrel.  Because your company has maintained a large supply of oil over the course of its existence, LIFO allows you to continue valuing your reserve inventory at much older prices, perhaps as low as $18/barrel!  The additional ramification of this decision is that your "cost of goods sold" is shown on your tax return at much larger current purchase prices, currently around $87/barrel.  This means that your "cost of goods sold" is higher than reality so long as inflation keeps prices above your historic purchase levels.  The increase in the COGS reducing your net taxable income.  The lower net taxable income means you pay less in taxes.  Thus, in a normal inflationary economy, the choice of LIFO will lower your total tax bill.

For some of you, this may seem grossly unfair.  Remember, though, that either accounting method has been legal since the 1930s.  Additionally, should the economy experience severe deflation, FIFO becomes the preferable accounting method to reduce taxation.  Because we normally see modest inflation, companies with very large inventories do tend to elect LIFO accounting methods.  While it's understandable why a corporation would make this election, is it in the best interest of society to allow for either option to exist?

The debate over the appropriateness of LIFO has been quietly going on for years.  Most recently, Democrats proposed the elimination of the LIFO accounting method during the debt ceiling negotiations.  The anticipated result of such a decision is projected to generate $72 billion in additional taxes from these companies which would reduce the federal deficit.  Republicans balked at this proposal claiming that it is a tax increase on business that would hurt jobs, and that LIFO is actually a more appropriate method as it better reflects economic gains over inflationary gains.  For the time being, Republicans have won out, and LIFO is still a legal accounting method.

The assertion that LIFO is more appropriate than FIFO due to economic gains is dubious.  Companies are charged with maximizing shareholder value, and LIFO is simply a better method for doing so in a normal economy.  Should America enter a long and severe deflationary cycle, many companies would switch to the FIFO method when possible to continue maximizing shareholder value.  This is their job.  When have large corporations ever advocated for legislation on the grounds of appropriateness over profitability?  Because of this, the arguments for keeping LIFO don't pass the smell test.

There is still a problem, though, in that companies can chose an accounting method to lower their tax bill.  To maintain parity between businesses, one standard accounting method should be adopted.  Standardizing the accounting method is not a tax on all business, as not all businesses chose the LIFO method.  Moreover, FIFO more closely resembles reality.  Older inventory does get sold--it doesn't simply sit on a shelf while newer inventory cycles in and out of the business.  Truly, the use of LIFO is simply a tax loophole created by accountants and should be eliminated in America. 

The elimination of LIFO would not be an innovation or place us at a disadvantage.  LIFO is already illegal in Europe and other westernized countries like Australia.  The arguments supporting LIFO accounting are flimsy and transparent.  Most important, though, the elimination of LIFO will make taxation across businesses inherently more fair.