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Revise Tax Treatment of Inventories

Repeal Last-In, First-Out (LIFO) Method of Accounting for Inventories

Many businesses hold inventories of goods, both inputs and products for sale. Because the purchase of inventory represents an exchange of cash for an equal value of assets, firms cannot deduct inventory when purchased. Instead, firms deduct the cost of inventory against the sale of goods in computing net profit. Because otherwise-identical goods moving out of inventory can have different costs, depending on when they were acquired, firms rely on specific conventions to account for the costs of goods sold.

Most companies use the first-in-first-out (FIFO) method, which assumes that the goods first purchased are the ones first sold. The cost of the goods on hand at the end of the year—the firm’s inventory—reflects the most recent purchases. Alternatively, companies can elect to use the last-in-first-out (LIFO) method if they also use LIFO for financial statement purposes. This method assumes that the goods last purchased are the ones first sold. This means that goods first purchased make up the firm’s inventory at the close of the year. If prices are rising, LIFO allocates higher costs to goods sold than FIFO, which reduces current taxable income and assigns a lower value to the year-end inventory.

The president’s budget proposes repeal of the election to use LIFO for income tax purposes. Taxpayers that currently use the LIFO method would be required to write up—that is, revalue—their beginning LIFO inventory to its FIFO value in the first taxable year beginning after December 31, 2013. To prevent a large spike in tax liability, this one-time increase in gross income from the write-up of existing inventory would be taken into account ratably over the 10 years beginning after December 31, 2013. The change would increase revenues by $73.8 billion over the next 10 years.

Under LIFO, as long as sales during a year do not exceed purchases, all sales are matched against purchases in the same year, and the opening inventory is never considered to have been sold. Therefore, a company that has used LIFO for many years will have a stock of inventory on its tax returns with a much lower value than its current acquisition price. Repealing LIFO and making companies pay tax on the accrued difference between the LIFO and FIFO valuations of their inventory would impose a substantial one-time tax (paid over 10 years under the proposal) and a smaller permanent annual tax as long as prices are increasing. Affected companies have benefitted from lower taxes in previous years, however, so the one-time tax could be viewed as repayment of those tax savings.

Proponents of repeal argue that LIFO has no value as a management tool and serves only to cut tax liability for a relatively small number of firms. Proponents of repeal also point out that LIFO is currently prohibited under the International Financial Reporting Standards. Opponents of repeal argue that LIFO makes the effective tax rate on inventory comparable to that on machinery and buildings and that repeal would overtax inventory. Further, they argue that in the presence of inflation, FIFO taxes firms on profits that represent changes in the price level instead of real economic profits and that LIFO may represent a better approximation of real economic income.

Repeal Lower-Of-Cost-Or-Market (LCM) Inventory Accounting Method

Companies that do not use LIFO may write down the value of their inventories by applying the lower-of-cost-or-market (LCM) method rather than the cost method, or write down the value of “subnormal” goods (ones that cannot be sold at the normal price or cannot be used as intended).

The president’s budget proposes to prohibit the use of the LCM or subnormal methods for taxable years beginning after December 31, 2013. The one-time increase in income due to revaluing existing inventories that were valued using these methods would be taken into account ratably over four years and increase federal revenue by about $13.1 billion through 2022.

The LCM and subnormal goods methods allow taxpayers to reduce taxable income for anticipated losses on inventories before the losses occur when the inventory is sold. However, there is no corresponding requirement that anticipated gains on inventories be included in taxable income before the gains occur. This asymmetric treatment accelerates inventory losses and defers inventory gains, misstating the timing of income and reducing tax revenues.

Additional Resources

Edward D. Kleinbard, George A. Plesko, and Corey M. Goodman, Is It Time to Liquidate LIFO? Tax Notes, October 16, 2006.
Alan D. Viard, Why LIFO Repeal Is Not the Way to Go, Tax Notes, November 6, 2006.