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Is It Time to Liquidate LIFO?
by by
Edward D. Kleinbard, George A. Plesko, and Corey M. Goodman
Document originally published in Tax Notes
on October 16, 2006.
This report discusses the role of the last-in, first-out (LIFO) inventory accounting
method in the current tax system, both as a matter of practice and of policy. The
authors examine the traditional justifications for LIFO and argue that LIFO, as it is
administered, is inconsistent with both its own objectives and with broader income
tax principles. LIFO, as practiced in the United States today, benefits only a narrow
range of businesses; they in turn rely on it entirely for its tax benefits, rather than to
complement normal business operations. Further, the evidence on LIFO suggests
that it creates inefficiencies in business operations, and may facilitate earnings
management. The authors conclude that any discussion of fundamental tax reform
must consider the repeal of LIFO.
The views expressed in this article are those of the authors and do not necessarily
represent those of their respective institutions. The authors thank Sarfraz Khan for
research assistance and John Phillips and Michael Redemske for comments. Any
errors are their own.
I. Introduction
In late April of this year, Sen Pete V. Domenici, R-N.M., proposed amending the
Internal Revenue Code to prohibit companies from using the last-in, first-
out method
to account for their inventories for tax purposes. The plan itself was removed from
consideration almost as soon as it was proposed, but talk of LIFO repeal in
Congress did not end and the issue was revisited in hearings before the Senate
Finance Committee in mid- June. This recent legislative interest in a targeted LIFO
repeal raises the issue of whether LIFO should be permitted generally, a topic that
has not been widely discussed in the tax policy literature.
This report summarizes and critically analyzes the key arguments in support of
LIFO
inventory accounting. We find that, as practiced today, LIFO accounting
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amounts to a massive tax holiday for a select group of taxpayers. This tax holiday is
inconsistent with larger income tax principles, cannot be justified even by the
arguments usually advanced by its proponents, and is not supported by global best
practices in financial accounting. We believe the proper response is for
Congress to
repeal the LIFO method of inventory accounting for tax purposes, preferably in the
context of broad-scale corporate tax reform.
We estimate that the explicit LIFO reserves of publicly traded companies totaled no
less than $60 billion in 2004 and almost $70 billion in 2005. Those figures
underestimate the total LIFO reserve for all taxpayers using LIFO accounting, if for
no other reason than because the data do not include privately traded firms.
Indeed,
the "LIFO Coalition," an ad hoc group of affected taxpayers dedicated to the
retention of LIFO accounting for tax purposes, has published a paper claiming that
the LIFO reserves of U.S. companies actually are "many times greater" than our
estimate of explicit LIFO reserves. For purposes of argumentation, we can
cheerfully accept the LIFO Coalition's emendation of our estimate and maintain that
it proves only that Congress is presented not with one tree bearing low-hanging tax
fruit, but rather with an entire orchard ripe for the picking.
We demonstrate in this report that there simply is no room in a principled income
tax for LIFO accounting. The purpose and effect of LIFO is to provide eligible
taxpayers with a deduction for an expense that is never incurred. The author of the
leading treatise on the taxation of inventories (who is also the author of the
memorandum submitted to the Finance Committee by the LIFO Coalition)
acknowledged exactly this point at the
beginning of his treatise's discussion of LIFO
accounting:
The single most important factor that has influenced taxpayers to adopt the
LIFO method is the tax savings that result from its use for tax purposes.
Theoretically, use of the LIFO method results only in a deferral of taxes.
However, as long as inflation continues and a taxpayer's LIFO inventories
remain relatively
constant or increase in size, the tax deferral is perpetuated and
tends to become 'permanent.'
LIFO thus provides a permanent tax deferral — a tax holiday — for a select class of
taxpayers. As such, it is inconsistent with the fundamental purpose of the income
tax, which is to tax the entirety of a taxpayer's annual accretion to wealth, whether
labeled "inflation-generated" or otherwise.
LIFO fails another fundamental principle of a well-designed income tax in that it is
not available to all taxpayers in all industries, but rather only to those that maintain
physical inventories and are not required to use another accounting method for
those inventories. Thus, the services industries are almost entirely excluded from
LIFO's tax holiday. Finally, LIFO serves no independent business or commercial
purpose: As demonstrated below, companies that employ LIFO for tax purposes go
to great lengths
not
to use LIFO for any observable nontax business
purpose, such
as capital budgeting or management compensation.
The avowed purpose of LIFO is to permit taxpayers to defer inflation-related
increases in inventory values. LIFO is described by its proponents as achieving a
better matching than does first in, first out (FIFO) between current revenue and
current expense, which in turn is said to further good tax policy, by "ameliorat[ing]
the harmful effects of inflation on capital investment." Thus, the memorandum
submitted to the Finance Committee by the LIFO Coalition early this summer
argued that LIFO fulfills a function analogous to the purpose underlying the code's
accelerated depreciation rules. As the remainder of this report describes in more
detail, however, that argument rings hollow, for several reasons. First, even taken
on its own terms, LIFO accounting for inventory is overgenerous because it
immunizes companies from paying tax on inventory gains attributable to factors
other than inflation. Second, LIFO accounting is not analogous to accelerated
depreciation or other timing benefits because LIFO accounting amounts in practice
to permanent, not temporary, reductions in tax liability. Third, unlike accelerated
depreciation, LIFO does not provide broad-based benefits to all taxpayers with
inventories.
More fundamentally, Congress rationally could have decided to encourage the
investment in productive plant or equipment, to increase the productivity of
American businesses and the collective wealth generated by the
economy. As
practiced, however, LIFO inventory accounting appears to encourage,
through a tax
subsidy, the systematic accumulation of inefficient levels of inventories, together
with a mechanism to manage earnings reported to both
shareholders and the tax
authorities.
Our principal focus in this report is on tax policy, not financial accounting. We
believe, however, that if LIFO were not permitted as a tax accounting method it
quickly would be rendered extinct in the financial accounting landscape as well
because LIFO, in practice, is a creature entirely of the tax ecosystem: The
ecological niche it occupies is entirely that of a tax-savings strategy, not a robust
alternative method to more fairly present companies' financial results.
The remainder of this report is organized as follows. Section II briefly describes the
role of inventory accounting methods in an income tax (and in financial accounting
systems). Section III lays out our core arguments as to why LIFO accounting for
inventories is fundamentally inconsistent with a principled income tax. Section IV
explains why LIFO accounting in fact fails to accomplish its own purported
objectives. Section V demonstrates that the "book- tax" conformity that purportedly
serves as a governor on the adoption of LIFO is illusory. Section VI describes how
LIFO accounting can give rise both to poor physical inventory management and to
financial accounting earnings management. Section VII reviews the available data
on the use of LIFO inventory accounting today and considers how Congress might
most productively go about excising LIFO from the code.
Finally, Section VIII briefly
summarizes our conclusions.
II. Inventory Accounting Methods
To understand
the arguments that follow, it is helpful to review briefly how LIFO and
other inventory accounting methods operate.
Physical inventories generally are necessary to run a business that depends on the
steady sale of similar goods to customers. The existence of physical inventories in
turn means that a taxpayer typically is simultaneously selling its goods to the public
and buying (or manufacturing) replacement goods — its inventories.
A
taxpayer's net annual income from the sale of goods that it manufactures or
purchases for resale simply equals its sales revenues minus its "cost of goods
sold." The purpose of inventory accounting methods is to determine, since a
taxpayer is selling its goods to customers and simultaneously buying (or spending
money to manufacture) replacement goods, which of the taxpayer's total costs
incurred during the year for the goods that it manufactures or purchases for resale
relate to goods sold during the year, and which of those costs are attributable to the
goods that remain on hand as inventory at the end of the year.
Every practical inventory accounting method makes that determination by adopting
an arbitrary ordering rule that assigns in some mechanical fashion the costs
incurred by the taxpayer during a year to manufacture (or purchase for resale) the
goods that it sells to the public to (1) the goods that the taxpayer in fact sold during
the year (that is, to the "cost of goods sold") and (2) to the taxpayer's goods
remaining on hand (that
is, in inventory) at the end of the year. Inventory accounting
methods thus provide a cost flow assumption that in no way needs to relate to the
physical flow
of goods produced and sold by a business. Allocating a greater
proportion of the taxpayer's total costs for the year to the cost of goods sold during
the year reduces current income and simultaneously reduces the value assigned to
the taxpayer's year-end inventories.
FIFO's arbitrary ordering rule for inventory costs is that the taxpayer's inventoriable
goods are
deemed to have been sold in the order purchased (or manufactured); the
costs associated with acquiring those goods are tracked as prices change, and the
earliest (first) costs incurred are assigned to the goods sold during the year. As a
result, the taxpayer's ending inventory is deemed to comprise the taxpayer's most
recently purchased or manufactured goods.
A collateral
consequence of FIFO's ordering rule is that FIFO tends to value
inventories on hand at year-end at levels that approximate their market values
(replacement cost). That result is consistent with underlying income tax principles
because those principles seek to include in income net annual increases in a
taxpayer's
wealth, to the extent those increases are visible and quantifiable through
"realization" events.
LIFO's arbitrary ordering rule is the opposite of
FIFO's: It assumes that the taxpayer
sells the most recently purchased (or manufactured) inventoriable goods first, so
that the taxpayer's first-acquired inventories are deemed never to be sold (unless
the taxpayer shrinks its inventories below historic levels). In a world of increasing
prices and constant (or increasing) inventory levels, a taxpayer that employs LIFO
inventory accounting will report less income than an otherwise identical taxpayer
employing FIFO because the LIFO firm will match its sales revenues against its
most recently purchased or manufactured (and therefore most expensive) inventory
costs. The difference in the amounts of income reported using FIFO or LIFO in turn
is offset by the difference in the values of the inventories a business reports under
the two methods on its balance sheet.
A taxpayer that
employs LIFO carries its year-end inventories at values that can
relate back to the taxpayer's adoption of LIFO —-
a date that often is decades in the
past. For example, a taxpayer that adopted LIFO in 1976 and that has not shrunk its
inventory levels since that date will carry its core inventories at values equal to their
1976 cost. When a taxpayer employs LIFO, "the day of reckoning is put off until the
cost of replenishing the taxpayer's inventory or its volume declines."
To provide better (if still imperfect) information about the actual values of LIFO
inventories to shareholders, financial statements ordinarily provide supplemental
disclosures on the difference between the LIFO cost of inventory as reported on the
balance sheet and what the value would be under FIFO or current cost. That
difference is referred to as the LIFO reserve or inventory valuation allowance. The
value of the LIFO reserve represents the cumulative amount of additional costs that
have been expensed by the firm because of the choice of LIFO over its alternatives.
III. LIFO Is Inconsistent With Tax Principles
LIFO accounting is inconsistent with larger income tax
principles in two fundamental
respects. First, LIFO accounting's theme of "matching current revenues to current
expenses" directly violates the principle that our income tax requires a taxpayer to
account annually for the income (that is, all increases to the taxpayer's wealth, to
the extent those
increases are observable) the taxpayer derives during a year. LIFO
accounting for inventory fails that standard because it typically yields a permanent
deferral of tax — the equivalent of a deduction for a cost that is never incurred.
Second, even if LIFO were restricted in application to purely inflationary gains
(which is not the case, as Section IV demonstrates), LIFO violates another
fundamental tax principle because it is a selective
partial immunization from inflation
— one that is neither available to all taxpayers, nor applicable to all similar assets,
in a consistent manner. The first part of this section expands on those two themes.
Congress of
course often deviates from rigid income tax theory to advance a larger
economic
or social agenda. The second part of this section demonstrates, however,
that there is no countervailing business or economic rationale that can excuse
LIFO's failures.
A. LIFO and Our Income Tax
One point on which even proponents of LIFO accounting agree with us is that the
practical effect of LIFO accounting is to grant a taxpayer that uses the method a
permanent
deferral — a tax holiday — in respect of the income attributable to
increases in the value (from whatever source) of inventory assets during the period
held by the taxpayer.
According to Boris Bittker and Lawrence
Lokken, "For taxpayers anticipating long-
term inflation in their industries, LIFO is an appealing option because its effect is to
postpone tax on inflationary gains in inventory indefinitely." Similarly, the authors of
one of the leading financial accounting textbooks point out that "As long as the
price
level increases and inventory quantities do not decrease, a deferral of income tax
occurs" under the LIFO method. Another volume on the tax aspects of LIFO
accounting notes, "The major advantages of LIFO are in periods of rising prices in
which LIFO eliminates 'inventory profits,' reduces federal income tax
and improves
cash flow." The LIFO Coalition's memorandum agrees, acknowledging that it would
not be unusual for a company to have employed LIFO to defer its tax liability "for
over 30 years." And the author of the LIFO Coalition's memorandum himself, in his
treatise on the taxation of inventories, has acknowledged that this tax deferral
"tends to become 'permanent.'"
Proponents of the LIFO status quo do not deny that LIFO operates in practice as a
permanent deferral of tax liability attributable to
increases in inventory values during
the period a taxpayer holds those inventories. Those proponents seek to justify that
result, however, on the basis that "when the proceeds of sale of an inventory item
are reinvested in a corresponding replacement item of inventory, there has been no
genuine economic
realization event." Another way of making that point is to observe
that LIFO accounting treats every sale of inventory property for cash in effect as a
partial tax
-free exchange. For example, if a retailer employing the LIFO method
acquires an item of inventory for $2 and sells it later at its market value of $6,
reflecting an increase in wholesale costs to the base price of $3, and a retailer's
markup of $1, LIFO accounting permits the retailer permanently to avoid any tax
liability on the $3 in appreciation in wholesale values during the period the retailer
held the asset.
Unfortunately for the proponents of LIFO, however, there in fact is a realization
event when inventories turn over — a sale of property for cash. An important
principle of our tax code is that income must be accounted for annually. We honor
that principle, for example, by requiring that tax be paid in the same year that
income is
"realized" (and recognized) by selling property. We do not allow
businesses to
avoid tax liability arising from the sale of property at a profit merely on
the basis that the profit has been reinvested in more business assets — that is the
essence of a consumption tax, not an income tax. Yet that is exactly the result that
proponents of the LIFO status quo seek to preserve for themselves.
Returning to the earlier discussion in Section II, it might be argued that because
both FIFO and LIFO are themselves arbitrary inventory ordering rules, objections to
LIFO amount to nothing more than an arbitrary preference for the method that
maximizes tax liabilities. To the contrary, FIFO in fact more clearly coincides with
income tax principles. (We are agnostic, however, on the question of which
inventory accounting method — other than LIFO — most accurately reflects the
goals of GAAP accounting.) Regardless of the method that a taxpayer employs to
account for its inventory, the taxpayer in
fact owns an asset (the inventory itself). An
ideal income tax would measure the values of a taxpayer's assets at the end of the
year, compare those values with the corresponding values at the beginning of the
year, and include the difference in income. By valuing closing inventories at figures
that converge on current replacement cost, FIFO plainly comes closer to this ideal
than does LIFO.
Another way of seeing that fundamental point is to imagine two
otherwise identical
taxpayers, one of which employs LIFO accounting for its 100 widgets in inventory,
and the other of which has perfected "just in time" (JIT) physical inventory
management, to the point where it never has any inventories on hand. Widgets in
the past have always cost $5; because the two taxpayers are otherwise identical,
one can imagine that the first has $500 tied up in widget inventories, and the other
$500 in cash in its sock drawer.
Now suppose that the price of widgets unexpectedly jumps to $9. The two
taxpayers are now no
longer equally wealthy: The first could sell its widget inventory
for $900 (whether in liquidation of its business, or by adoption of equally efficient JIT
physical inventory management methods), while the second still has just the same
$500 hidden in its sock drawer. Yet LIFO accounting treats the two taxpayers
identically — as if the first enjoyed no greater accretion to wealth for its tax year
than did the second.
In summary, the LIFO method partially suspends the application of the realization
principle for some sales of property (LIFO inventories) for cash — and by doing so,
deviates from a comprehensive effort to capture in the taxpayer's annual income
current increases in a taxpayer's wealth (including increases in the value of
inventories, like any other property), as documented through actual realization
events. By turning sales of inventory for cash into effective tax-free exchanges,
LIFO accounting for inventories functions as an effective tax holiday for those firms
that employ it. In short, in this fundamental respect LIFO accounting produces
results directly in opposition to the purpose of an annual income tax.
A second
-order failing
of LIFO when measured against income tax principles is that,
even if it were restricted to accomplishing its purported objective of immunizing
taxpayers only from purely inflationary inventory gains (which in fact is not the case,
as demonstrated in Section IV, below), that objective would not be sufficient
because it would be underinclusive. That is, this idealized inflation-immunization
program would be available only to some taxpayers in some businesses — those
with physical inventories and that are otherwise eligible for
LIFO accounting.
Inflationary gains are not unique to inventories, yet even an idealized LIFO
accounting system would reach only one class of assets. Any time the code
privileges one class of assets over another, it distorts economic behavior. In this
case, the distortion is to encourage taxpayers to maintain physical inventories
beyond the levels they might otherwise need, simply to avoid recognizing layers of
built-in (and as-yet indefinitely deferred) LIFO inventory gains. We return to this
theme in Section VI.
To be clear, inflation is a very important issue in the design of any income tax
system. Our tax system today largely deals with inflation by ignoring it, at least
explicitly (with the exception of some tax bracket adjustments and the like). Our
point in criticizing the argument that LIFO appropriately responds to inflation
concerns is not to trivialize the importance of inflation, but rather to maintain that ad
hoc and selective solutions like the LIFO accounting method distort economic
decisionmaking even more than does not addressing the issue at all.
It might be argued that the LIFO method is a completely acceptable inventory
accounting method under U.S. GAAP, which surely must mean that we must be
mistaken in our argument that LIFO accounting is inconsistent with a principled
income tax. It is true that LIFO is a recognized GAAP accounting method, but that
fact does not mean that its purpose or effect necessarily is
consistent with the goals
of our income tax system. As the Supreme Court explained in a case dealing
directly with inventory valuation methods, appropriate (or at least permissible)
financial accounting inventory methods sometimes conflict with the design and
purpose of our income tax. In those
cases, the financial accounting method must be
rejected for tax purposes.
In sum, once one sees LIFO for what it is — an ersatz basis indexation scheme
available only to some taxpayers in some businesses — it becomes apparent that
LIFO functions as just another preferential tax break available only to some
taxpayers, but paid for by all, through the higher tax rates needed to raise the same
aggregate revenues. LIFO is demonstrably inferior to FIFO in the core income tax
objective of capturing a taxpayer's annual accretions to wealth, whenever those
accretions are observable, and even a hypothetical idealized version of LIFO would
distort economic decisionmaking through its incomplete scope.
B. LIFO Is Not Justified by Other
Goals
If the code perfectly embodied only idealized income tax principles, it would be
much shorter in length, but draconian in application. Congress frequently and
consciously deviates from those principles to accomplish goals of administrative
simplicity, or of fairness, or to encourage activities that are thought to advance
larger economic or social agendas. Unfortunately for proponents of the LIFO status
quo, however, the LIFO accounting method cannot be justified by any of those
countervailing concerns.
Proponents of the LIFO status quo have argued that LIFO accounting results in a
timing benefit, and as such is analogous to accelerated depreciation or other timing
benefits conferred by Congress. In fact, the analogy is inapposite, for two reasons.
First, as the preceding section demonstrated, in practice LIFO accounting operates
as a permanent (or near permanent) deferral of tax liability — a true tax holiday.
Second, and more fundamentally, what larger purpose is served by maintaining
historic levels of inventories, simply to avoid LIFO recapture? Congress provides
incentives for investment in productive plant and equipment because those
investments improve the productivity of a broad range of American businesses, and
with it the wealth of all Americans. None of us wins, however,
by having capital tied
up in inventories simply to perpetuate LIFO accounting's indefinite tax deferral
scheme.
It has been suggested by the LIFO Coalition that "if the LIFO method were
repealed . . . this would tend to cause businesses to try to increase the selling
prices of their goods . . . thus further exacerbating inflationary tendencies." That
argument plainly collapses under its own weight. Businesses today do not
gratuitously refrain from taking advantage of price increases out of gratitude for the
government's continuing to make LIFO available to them. The laws of supply and
demand drive prices today, and will tomorrow, regardless of the accounting
methods employed by businesses
for their inventories. More generally, by removing
a tax subsidy for one form of capital investment, LIFO repeal will lead to a more
efficient allocation of
capital across the economy. Further, LIFO repeal, coupled with
other base-broadening provisions that could be adopted as part of fundamental tax
reform, could facilitate a reduction in tax rates to all businesses, and thereby
increase after- tax returns on all assets.
Nor can the LIFO
accounting method be justified as advancing any nontax business
or commercial objectives. Despite the arguments of proponents of the LIFO status
quo that LIFO serves a nontax purpose, LIFO accounting thrives only in
environments in which it is accompanied by associated tax benefits: It is entirely a
creature of the tax ecosystem. LIFO is "grounded in its favorable impact on tax
liabilities, rather than its theoretical merits for providing useful information to the
capital markets." James Leisenring, an International Accounting Standards Board
(IASB) member and former Financial Accounting Standards Board director, has
publicly stated, "I don't think anybody thinks LIFO is a good inventory method
for
anything except tax purposes." In a world without taxes, there is little evidence that
any taxpayer would use LIFO accounting to fairly present its financial results.
In countries without LIFO tax accounting, LIFO financial accounting is rarely used.
In this country, companies' creative avoidance of the only current governor on LIFO
abuse, the book-tax conformity rule (discussed in Section V, below), shows that in
fact they do not believe that unadulterated LIFO financial reporting conveys an
accurate picture of their financial results.
If the use of LIFO were primarily motivated by nontax commercial objectives, we
would expect LIFO to be an integral part of firms'
operations, but that does not
appear to be the case, as explained in a leading accounting textbook:
Many companies use LIFO for tax and external reporting purposes but maintain a
FIFO, average cost, or standard cost system for internal reporting purposes. There
are several reasons to do so: (1) Companies often base their pricing decisions on a
FIFO, average, or standard cost assumption, rather than on a LIFO basis. (2)
Record keeping on some other basis is easier because the LIFO assumption
usually does not approximate the physical flow of the product. (3) Profit-
sharing and
other bonus arrangements are often not based on a LIFO inventory assumption.
Finally, (4) the use of a pure LIFO system is troublesome for interim periods, for
which estimates must be
made of year-end quantities and prices.
If pricing decisions and management bonuses are not based on LIFO accounting
results, the clear message is that companies do not consider LIFO a cost
assumption appropriate in measuring their own performance.
IV. The Failures of the LIFO Method
LIFO accounting for inventories fails even its avowed purpose of properly
immunizing taxpayers from paying tax on "phantom" inventory gains attributable to
inflation. It does so by being overinclusive in the gains that it permits taxpayers to
defer. In brief, the LIFO method of accounting permits taxpayers to defer income
attributable to all cost increases in their inventory, including not only cost increases
due to inflation, but those due to fundamental shifts in the equilibrium between
supply and demand, or to years of incremental technological improvements to their
inventoriable goods.
LIFO accounting thus simply is ineffective at distinguishing between pure
inflationary increases in costs, fundamental supply/demand imbalances, or
engineering or other technological enhancements, that in any case increase the
cost (and the value) of a taxpayer's inventoriable goods — even in a hypothetical
world of zero inflation. We term this phenomenon the "value
creep" problem.
One recent and dramatic example has been the steep run
-
up
in crude oil prices
over the last 24 months. That run-up is not commensurate with inflation rates, but
rather reflects both global security issues and fundamental supply/demand
imbalances. By one measure, the taxable income deferred by U.S. large integrated
oil companies through LIFO accounting for 2005 alone through this "value
creep" (that is, changes in the value of inventory that are not inflation-related) might
have been on the order of $19 billion.
LIFO — and in particular "dollar value" LIFO, as employed by many retailers and
manufacturers — fails to account for value creep in other respects as well,
particularly regarding retailers. The reason is that one purpose of dollar value LIFO
is to obviate having to make distinctions between the nature of the goods that
comprise closing inventories and those in beginning inventory, even though the
goods in closing inventory "may, and generally do, differ considerably as to type,
quality and price from those in the beginning inventory." Technological
improvements over time may reduce a manufacturer's costs of manufacturing an
item of inventory, but by the same token new standard features can increase both
the value and the cost of inventory for retailers, in particular, by amounts that
exceed any reductions attributable to lower manufacturing costs. As those new
high-value improvements accumulate in an item of inventory without it being
redefined as a new "item" for LIFO purposes, the taxpayer can defer ever-
increasing amounts of income, not simply because of inflation, but because the
taxpayer is matching the expense of selling state-of-the-art goods against the
revenues from selling older inventory.
To see the value creep problem more clearly, imagine an automobile retailer that
maintains an inventory of cars and had adopted LIFO accounting in 1976. Thirty
years later, the engineering and build quality of cars have improved, standard
features have been added, manufacturing has become
more efficient, and there has
also been inflation. For LIFO to isolate inflation, it must somehow separate all of
those improvements and changes, even though they have occurred incrementally
over time (such that each year's model is only a slight improvement over the prior
year's). In the absence of separating out those different components of changing
cost (and value) — which current law does not require, and which would be
unadministrable if one were to attempt to do so —
dollar value LIFO permits deferral
of income attributable to all of those factors, not just inflation, unless and until the
differences in degree of the nature of an item become so extensive as to require
defining a new item.
To isolate price increases attributable solely to inflation, one must compare the
costs of producing (or buying) apples in one year with the cost of producing (or
buying) apples — or at least other forms of hand fruit —
in other years. The purpose
of the word "item" is to make sure that the production or acquisition costs being
compared relate to the same kind of good — and not, to continue the analogy, to
apples in 1976 but to steak in 2006. If a taxpayer's inventory tax accounting
methods define apples as the same
"items" as steak (for example, "foodstuffs"), the
increased acquisition cost of steak over apples would be caused by the substitution
of goods, rather than inflation in the market for hand fruit. Very generally, therefore,
a narrower definition and interpretation of the word "item" leads to a better isolation
of the inflationary component of increased inventory costs, and also the risk of
imposing higher administrative burdens on taxpayers.
The Tax Court wrestled with exactly this issue in a case involving a new car dealer
at a time when automobiles were undergoing rapid technological evolution. In that
case, the taxpayer was an automobile dealer; its items of LIFO inventory comprised
new cars and new trucks. The question was whether the introduction of catalytic
converters and new solid state ignition systems in 1975 meant that 1975 new cars
were not sufficiently similar to 1974 new cars as to be the same item. As it
happens,
the Tax Court concluded that those engineering developments were not
sufficient to
make 1975 cars different items from 1974 cars. The Tax Court also rejected the
taxpayer's argument that a "car is a car," but declined to offer any further guidance,
other than to hold that the issue of the point when an original item has evolved
(through value creep or otherwise) into a new item must be determined on a case-
by-case basis — hardly a clear standard for future decisions.
As that summary suggests, it is very difficult to decide where
to draw the line: Are
1976 new cars, for example, the same item as 2006 new cars
in the hands of a new
car dealer? The case-by-case approach used by the courts and the IRS in drawing
the line is far too ambiguous in application to ensure that taxpayers will not use
LIFO accounting to offset price increases unrelated to inflation. The tremendous
practical difficulties in policing that distinction are sufficient by themselves to justify
the repeal of the LIFO method of inventory accounting (or at least, its dollar value
variant).
If in fact Congress wanted to mandate an inventory accounting method for tax
purposes that immunized taxpayers from paying tax on "phantom" inventory gains
attributable solely to inflation, rather than value creep, Congress could do so by
repealing LIFO and replacing that accounting method with FIFO inventory
accounting coupled with indexation of the basis of inventory assets — and no other
class of property or investment — for inflation each period. Some 20 years ago, in
the context of larger-scale corporate tax reform, the Treasury Department made just
such a proposal.
This "indexed FIFO" system would be superior to LIFO in
one critical respect, which
is that it would include only inflationary
gains in the deferral mechanism, and not the
value creep that we described above. The result, however, would still be an
effective deduction (the upwards indexation of the cost of goods sold) for an
expense that is never incurred. Even indexed FIFO thus would appropriately be
subject to the criticism that inflation affects all capital investment. If we are not to
introduce new distortions into economic decisionmaking, inflation must be dealt with
systematically throughout the code
—
not in a piecemeal manner.
V. LIFO Book-Tax Conformity Is Illusory
As
Section III demonstrated, LIFO accounting provides a pure tax holiday for
taxpayers that employ it. Congress implicitly recognized that fact when it first
permitted LIFO accounting by adopting an artificial governor on a taxpayer's ability
to adopt LIFO accounting — the book-tax conformity rule. The purpose of that rule
was to dampen the attractiveness of adopting LIFO
tax accounting, by requiring
taxpayers that did so also to use LIFO financial accounting. The presumption was
that if the nontax detriment to a taxpayer of employing LIFO accounting exceeded
the tax benefit, the taxpayer would choose another accounting method.
Regardless of the wisdom of that original strategy, there is no real book-tax
conformity in our tax system; it is illusory. In fact, in an April 13, 2001, letter to
Treasury Secretary Paul H.
O'Neill, Edmund Jenkins, then serving on FASB, argued
for repealing LIFO conformity simply on the basis that conformity was not, in
practice, taking place. A taxpayer can satisfy the conformity requirement even if it
uses different LIFO submethods for its financial statement and tax accounting
statements. Also, public corporations that use LIFO accounting methods for tax
purposes almost invariably also disclose (in footnotes) what their profits would have
been under a FIFO accounting method. Those footnotes are both clearly
written and
closely read by securities analysts, suggesting that those issuers perceive a great
benefit in disclosing what they perceive to be their real book income, and in the
process subverting the supposed conformity
requirement. Most tellingly, a company
that employs LIFO accounting for tax purposes need not use LIFO principles for
internal capital allocations purposes, new project feasibility studies, management
compensation, or any other genuinely commercial decisions.
The accounting literature agrees with that assessment, noting, "The LIFO
conformity rules set forth in IRS regulations permit numerous disclosures of
financial information on a non-LIFO basis." For example, while the taxpayer must
prepare the face of its financial accounting income statement using a LIFO
inventory method, it may supplement that statement with a note or appendix, or
publish news releases, hold press conferences, and pepper various sections of its
annual report with alternative accounting methods. A company may also use
alternative measures in its forecasts and in reported income statements covering
periods under one year in duration. As a result, corporations that employ LIFO
accounting to drive down their effective tax rates can give shareholders and
creditors explicit information as to what their profits would be under FIFO
accounting and still satisfy the conformity requirement of section 472(c).
Given all of those exceptions and loopholes, it is clear that book-tax conformity as it
is currently practiced does not impose any material constraints on how public
companies communicate their financial results to public investors or creditors. A
larger question is,
what purpose would be served by an efficacious book
-
tax
conformity rule? The rule appears originally to have been grounded in a notion that
LIFO's adoption for tax purposes should be artificially constrained by requiring
companies to "put their money where their mouth [is]" for financial statement
purposes. But that rationale in turn is an implicit acknowledgement that LIFO
accounting produces results that are undesirable for tax purposes — why else
would an
artificial governor on its scope be required?
The real conformity that Congress should employ as its lodestone is
conformity with
nontax commercial decisionmaking. In 1993, for example, when Congress required
securities dealers to employ mark-to-market accounting for tax purposes, one of
the
principal rationales was that dealers consistently employed mark-to- market
accounting for important commercial purposes. More recently, proposed Treasury
regulations under section 475 that adopt a book-tax conformity "safe harbor" for
securities dealer inventories also explicitly are premised on the fact that the real
conformity at issue is not between "book" and "tax," but rather between book and
tax, on one hand, and demonstrable nontax commercial decisionmaking on the
other. The absence of consistent evidence that companies base management
compensation or any other commercial decisions on LIFO financials again illumines
LIFO's role as an artifice of pure tax avoidance.
Figure 1. Firms With Inventories and LIFO Reserves
VI. LIFO-Induced Distortions
LIFO accounting
for inventories provides incentives for corporations to manage both
their inventory levels and their financial statement earnings for artificial reasons.
LIFO encourages poor physical inventory management by encouraging
corporations to maintain unneeded levels of inventories to avoid liquidating a LIFO
layer, thereby protecting the lower cost of goods acquired in an earlier period from
being matched against sales revenues from the current period. The implicit
incentives that LIFO provides for tax- protective year-end purchasing are well
understood in the academic literature. For example, the authors of one of the
leading accounting textbooks state: "Because of the liquidation problem, LIFO may
cause poor buying habits. A company may simply purchase more goods and match
these goods against revenue to avoid charging the old costs to expense."
Micah Frankel and Robert Trezevant show that in practice, the
LIFO method does in
fact distort inventory choices. They examine the year-end purchasing decisions of
firms as a function of the firm's inventory accounting methods and tax status and
report that (1) high- tax LIFO firms are more likely to purchase extra inventory at
year- end than low-tax LIFO firms, (2) LIFO firms are more likely to purchase extra
inventory than FIFO firms, and, by contrast, (3) FIFO firms do not show differences
in purchasing that are related to their tax status. The authors conclude that their
finding "that additional year-end LIFO inventory purchases appear to be made for
tax reasons suggests that permitting the LIFO method to be used for tax purposes
leads to inventory management inefficiencies." For firms to purchase additional
inventory despite the incremental costs shows how significant the tax benefits can
be and further demonstrates the distortion in firm behavior LIFO can cause.
Second, instead of purchasing more at year-end to maintain inventories,
corporations can
use the LIFO method accounting to do the opposite, relying on the
liquidation of LIFO layers to reduce inventories and thereby release earnings. In
fact, Lawrence Revsine, Daniel Collins, and W. Bruce Johnson have shown how
firms can use LIFO to manage multiple years' earnings (both up and down) to meet
targeted levels through year-end purchases or liquidations. The authors of one of
the leading accounting textbooks also note that phenomenon: "With LIFO, a
company may attempt to manipulate its net income at the end of the year simply by
altering its pattern of purchases." Even the author of the leading treatise on the
taxation of inventories (and the author as well of the memorandum submitted to the
Finance Committee by the LIFO Coalition) writes: "LIFO taxpayers may have a
greater degree of control over earnings than taxpayers using another inventory
method."
In addition to allowing for opportunistic inventory management to achieve financial
reporting objectives, LIFO appears to also provide conflicting incentives for the
adoption of more efficient management of physical inventories. On one hand, the
ability to liquidate LIFO layers and generate additional reported income may
facilitate some firms' adoption of JIT inventory methods because the additional
income from LIFO liquidation can be used to offset the additional reported costs
incurred in the same period to implement JIT. Taxable firms with large LIFO
reserves, however, have been found to be less likely to adopt JIT because of the
tax consequences of LIFO
liquidations. Further, the evidence suggests that firms
with a history of
managing their reported earnings were also less likely to adopt JIT.
As a
result, it appears that the adoption of new inventory management techniques
may actually be hampered by the use of LIFO.
VII. Getting Serious About LIFO Repeal
A. What Is at Stake, and for Whom?
As we described in the opening paragraphs of this article, the
explicit LIFO reserves
of publicly traded U.S. firms total nearly $70 billion, and at least one industry group
newsletter has suggested that reserves could be an order of magnitude greater.
Those reserves represent an extraordinary amount of forgiven tax for a relatively
small number of companies and are lumpily distributed across the American
economy. Like other outside analysts, we are limited by our lack of access to actual
tax return information, and published IRS composite data do not allow us to
determine the number of corporate tax returns containing inventories valued under
any method. In this section, we nonetheless attempt to reconcile the data that are
available from a number of public sources.
While a precise calculation of the number of companies using LIFO inventory
accounting cannot be made with publicly available data, we have compiled data
from several sources that imply that LIFO tax accounting is on the decline. We see
that evidence as demonstrating that the extraordinary tax benefits of LIFO
accounting are concentrated in fewer and fewer companies.
Figure 2. Use of LIFO by Firms With Inventories
Data on taxpayers' use of LIFO inventory accounting must be examined with care
because of a seeming contradiction: Publicly available data will simultaneously
overstate the use of LIFO as an inventory accounting method by businesses and
understate the potential revenue
effects of changes to LIFO. The understatement of
revenue is easiest to understand, as publicly available data exclude both estimates
of the value of LIFO to non-publicly-traded firms, and the LIFO reserves attributable
to many companies that have been acquired in transactions accounted for under
the "purchase method" but were not asset sales for tax purposes. The overestimate
of the use of LIFO (when measured as a percentage of all firms) arises from what
appears to be a greater incidence of LIFO use among publicly traded firms than by
businesses generally.
To obtain the most precise estimate of the number of businesses that use LIFO
would necessitate access to businesses' tax
returns, which require both a
disclosure of inventory methods and, if LIFO is used, the percentage of closing
inventory valued under LIFO. Such a tabulation
was apparently performed as part of
the Reagan administration's initial tax reform study ("Treasury I") released in 1984.
In discussing inventory accounting methods, Treasury reported, "Roughly 95
percent of firms with inventories use FIFO accounting for tax purposes." We note
four specific implications from that simple statement: First, Treasury's analysis
included all businesses, both public and private and regardless of their choice of
entity (that is, the analysis included corporations and partnerships). That fact is
important because publicly available entity-level data is limited to publicly traded
corporations. Second, Treasury's tabulation restricted itself to those businesses that
maintained inventories — a number far smaller than the number of businesses
generally. Third, Treasury specifically identified FIFO-only firms and did not
separately identify whether the remaining firms used LIFO-only, a combination of
LIFO and FIFO, or some other inventory method. As a result, the statement
suggests that the maximum percentage of all inventory-holding businesses that
used LIFO for any portion of their inventories was 5 percent. Finally, as we explain
below, it is likely that both the absolute number and the percentage of firms using
LIFO would be substantially lower today, as the time period analyzed in Treasury I,
the early 1980s, appears to represent a time when LIFO use reached a peak.
To estimate the use of LIFO by publicly traded firms we collected inventory data
from the Compustat database of firms' annual 10-K filings for 1975 to 2005. In
Figure 1, we graph the number of firms reporting
any amount of inventory at the end
of each year, along with the number of firms reporting a LIFO reserve. Over that
time, the number of publicly traded firms with inventories ranged from 5,000 to
8,000, while the number reporting a LIFO reserve exceeded 1,000 from the late
1970s to the late 1980s, and steadily declined thereafter.
In contrast to Figure 1's presentation of aggregate data, Figure 2 provides
information on the relative use of LIFO over the same period. The dark solid line in
the middle of Figure 2 is the percentage of firms
with inventories that report a LIFO
reserve, and is calculated from the data presented in Figure 1. The pattern in that
line is clear: The relative use of LIFO peaked in the early 1980s and has steadily
declined since, with fewer than 10 percent of firms with inventories reporting a LIFO
reserve in 2005.
We present two additional tabulations of LIFO use based on a smaller sample of
firms for which Compustat provides information on the inventory methods that the
company reports it employs. First, the dark dashed line that appears at the top of
Figure 2 represents the percentage of firms that report using LIFO for any of their
inventories. That percentage can be higher than the one estimated from the data in
Figure 1 if firms with inventory did not report a LIFO reserve because of materiality,
or simply because of differences in the sample of firms. Second, the light dashed
line shows the percentage of firms that report using LIFO exclusively.
Regardless of the data used, or the
way in which it is analyzed, two conclusions are
inescapable. First, the
absolute and relative use of LIFO by U.S. firms peaked in the
early 1980s and has been steadily declining ever since. Second, regardless of how
it is measured, either by any use or exclusive use, LIFO inventory accounting is not
widely employed by businesses. Taking the most generous estimates from Figure 2,
at the end of 2005 only 12 percent of publicly traded firms used LIFO for any
portion
of their inventories, and fewer than 2 percent used LIFO exclusively.
Figure 2 relates to our observation made at the beginning of this section about the
use of LIFO by all firms, public and private: Given that the percentage of publicly
traded firms that used LIFO for any portion of their inventories peaked in the early
1980s, and their use of LIFO has steadily declined, it also seems likely that the use
of LIFO among privately held firms would also have declined.
We conclude that the number of businesses that benefit from the use of LIFO is
small, not only when compared with the business sector as a whole, but even when
compared with businesses that maintain inventories. In that regard, we note that
other reports of LIFO use do not clearly differentiate between any use and exclusive
use. We also note that the goals of simplicity in compliance and administration are
clearly violated when firms choose to employ multiple inventory accounting methods
solely to maximize their tax benefits.
B. How Large Is the LIFO Deferral?
It is possible to estimate, with a fair degree of accuracy, what we have termed in
this report as the "explicit" LIFO reserves of publicly held firms. Those data are
incomplete, of course, in that they do not capture the magnitude of private firms'
LIFO reserves, but for the reasons described below we do not believe that adding
the data for privately held firms would materially affect our estimate.
A more important deficiency in our
"explicit" LIFO reserve figures is that they
probably understate the actual magnitude of the tax revenues that would be raised
from a repeal of the LIFO
method of inventory accounting because of the
application of "purchase" accounting principles to business combinations. Very
simply, if one company acquires another in a transaction that is accounted for as a
"purchase" but is not treated as a taxable asset acquisition for tax purposes, the
effect of applying purchase method accounting to the acquired company's assets is
to mark those inventories to their current value, thereby (phrasing matters
colloquially) wiping out that company's financial statement explicit LIFO reserves at
the time of its acquisition. At the same time, the acquired company's tax LIFO
reserves would remain intact.
Before an acquisition, no material book-tax difference ordinarily would exist
regarding the acquired company's inventory valuations because both would be
computed under LIFO, typically following similar principles. The application of
purchase method accounting to an acquired company, however, creates a
significant book-tax difference, attributable to "marking-to-market" that company's
inventories for financial accounting purposes, but not for tax purposes. That book-
tax difference in turn gives rise to a new deferred tax liability: In other words, and
again phrasing matters colloquially, the acquired company's former explicit LIFO
reserve migrates to a component of the acquirer's deferred tax liability. While a firm
is expected to describe in its financial statement footnotes the material components
of its deferred tax liability, there traditionally has been a wide range of actual
practice regarding deferred tax liability disclosure, and, in any event, we know of no
publicly available database, such as Compustat, that aggregates firms' footnote
disclosures of the components of their deferred tax liabilities. Moreover, for
technical reasons, the aggregated 2004 Schedule M-3 data recently published also
shed no light on the magnitude of former explicit LIFO reserves that, by virtue of
acquisitions, are now a component of deferred tax liabilities.
Figure 3. The Magnitude of LIFO Reserves
Since 2001 GAAP has mandated the use of purchase accounting for all business
combinations, and even before that date a large number of transactions were
accounted for under those rules. Moreover, it is the norm in
acquisitions of domestic
companies (other than acquisitions of corporate subsidiaries) to structure the
transaction to avoid triggering asset-level gain
recognition to the acquired company.
As a result, our $70 billion estimate for
the income that would be recognized from
the repeal of the LIFO method of
accounting must, as a practical matter, represent a
floor on the actual amount at stake.
For the reasons described above, we cannot estimate the
magnitude of the invisible
(to the public) LIFO reserve attributable to the "migration" of former explicit LIFO
reserves to deferred tax liabilities. We acknowledge, however, that the LIFO
Coalition may be correct when it asserts that the effect of purchase method
accounting in understating the actual LIFO reserves of public companies for tax
purposes may be "many times" greater than the visible explicit reserves
themselves.
Figure 3 presents annual data on the aggregate amount of explicit LIFO reserves
reported by publicly traded firms (the gray bars, measured on the left y-axis) and is
an estimate of the amount of income cumulatively deferred at the end of each year.
Consistent with the use of LIFO documented in figures 1 and 2, the aggregate
nominal value of explicit LIFO reserves also peaked in the early 1980s, but remains
significant. In contrast to Figure 2, however, the aggregate value of explicit LIFO
reserves does not appear to have declined in direct proportion to LIFO's use,
suggesting that the benefit of LIFO has become more concentrated over time. As
we described in the opening paragraphs of this article, explicit LIFO
reserves for
publicly traded companies in this country were nearly $70 billion at the end of 2005.
Assuming a tax rate of 35 percent, the inclusion of that
reserve in taxable income
would generate $24.5 billion in federal corporate tax
revenue from publicly traded
firms alone.
We also plot the value of explicit LIFO reserves as a percentage of the end of year
inventories of companies with a LIFO reserve (the solid line corresponding to the
right y-axis). That line represents the extent, in percentage terms, that the inventory
values reported by LIFO firms are understated relative to the market value of the
inventory. While the figure was clearly much higher in the 1980s, at the end of 2005
the average LIFO firm's inventories were understated by nearly 20 percent.
As previously stated, without access to businesses'
tax returns, it is difficult to know
the extent to which private businesses will be affected by LIFO repeal but the
proportion is likely small. The fact that the total number of companies using LIFO
may be many times larger than the number of
publicly traded firms using LIFO does
not imply that the revenue effects of changing LIFO would be many times the
amount inferred from data available from publicly traded firms. While there are a
large number of businesses subject to
the corporation income tax, aggregate
economic activity and inventories are concentrated among the very largest firms.
IRS data for 2003 (the most recent year available) show that 5.4 million corporate
tax returns were filed and that those businesses reported a total of $53.6 trillion in
assets. Of those 5.4 million returns, only 2,018 returns (a miniscule 0.04 percent of
the total) reported assets in excess of $2.5 billion, yet those same 2,018 returns
reported more than 75 percent of all assets and were responsible for 67 percent of
the total amount of net income (less deficit). If the size threshold is lowered to
returns with at least $100 million in assets, there were 20,477 returns filed (0.38
percent of the total), and they reported 93 percent of all corporate assets and 85
percent of net income (less deficit).
Regarding inventories, the 2,018 largest returns reported 34 percent of all
inventories, and the 20,477 largest returns reported 60 percent of all inventories.
Those percentages are likely understated, however, because the balance sheets of
firms using LIFO understate the value of inventory relative to other inventory
methods (for example, FIFO). As described above, the understatement is likely
greatest among the largest, publicly traded firms.
C. Consequences of LIFO Repeal
Even among publicly traded firms using LIFO, the effect of changes in LIFO will be
concentrated among a relatively small number of firms. Based on 2004 financial
statements, 50 percent of the total LIFO reserve was attributable to only 13
companies, and 80 percent was attributable to 56 companies. In the next year,
2005, 50 percent of the total LIFO reserve was attributable to a mere 8 companies,
and 80 percent to 42. In short, as with many corporate tax changes, changes in
revenue from the repeal of LIFO are likely concentrated among the largest, publicly
traded firms.
Even without knowing what alternative inventory method(s) might be permitted, the
repeal of LIFO accounting for inventories should have only minor financial reporting
consequences. First, only a minority of publicly traded firms with inventories appear
to use LIFO for any portion of their inventories. Second, as we
demonstrated above,
LIFO book-tax conformity has been so diluted over the years that only the most
naïve reader of financial statements today analyzes a public company's results by
reference to its LIFO numbers.
LIFO repeal should not adversely affect the balance sheets of business taxpayers
because the consequence of LIFO repeal would (eventually) be to increase the
carrying values of inventories to their current replacement cost values, or increase
cash as firms more efficiently manage smaller inventories. If anything, it can be
argued that balance sheets in general will look stronger after LIFO repeal.
LIFO repeal also should
not
affect international
competitiveness, for the simple
reason that LIFO is almost entirely a creature of U.S. accounting practice. Because
most foreign countries do not permit LIFO accounting for inventories, foreign
subsidiaries of U.S. firms will be in exactly the same competitive position after LIFO
repeal as they were before. The consolidated financial statements of U.S. firms
attributable to the activities of those subsidiaries already reflects the inventories
carried by those subsidiaries on a basis other than LIFO, and therefore would be
completely unaffected to that extent by the repeal of LIFO.
As a result, it is
difficult to imagine that U.S. firms that currently use LIFO would be
at a disadvantage were they required to use the same accounting as their
competitors. Further, firms using LIFO do not appear to use LIFO costs for pricing
or other businesses decisions, implying that the ability of a U.S. firm to compete is
already independent of the availability of LIFO.
Nevertheless, the repeal of LIFO by itself can be expected to present a cash flow
issue for those companies that have employed LIFO for many decades. That cash
flow problem is no different, however, than the cash crunch faced by individual tax
shelter "junkies" in the 1970s, when the code was amended to foreclose most
individual shelters, or the cash crunch faced by any other group of taxpayers that
have enjoyed preferential tax treatment, when that preference is taken away.
The solution to that cash crunch issue is twofold. First, we believe that LIFO repeal
most appropriately should take place in the context of fundamental corporate
income tax reform, in which the income tax base is
broadened and rates lowered. In
that context, the cash costs of LIFO repeal will be mitigated, although the extent of
that mitigation will vary from firm to firm.
Second, legislation to repeal LIFO also should permit taxpayers to pay the taxes
attributable to the LIFO tax deferral that they previously enjoyed over a period of
years. For example, when Congress added section 475 to the code in 1993 to
require securities dealers to change to a mark-to-market system to account for their
inventories of securities, the dealer community faced exactly the same sort of one-
time cash crunch. Congress recognized the problem by
permitting securities dealers
to pay the back taxes attributable to the deferral benefits they previously had
enjoyed ratably over five years (without any interest charge). We recommend that a
similar rule be adopted in connection with LIFO repeal.
VIII. Summary and Recommendation
The repeal of LIFO as a permissible tax accounting method for inventories will
impose transition costs on some taxpayers (in dollar terms, mostly a surprisingly
concentrated number of our largest public corporations), but make major strides in
achieving a more principled income tax by more closely
approximating an economic
measure of taxpayers' incomes. Repeal would eliminate the incentive to invest
business resources in maintaining an inventory
accounting system that would likely
not be chosen but for its tax benefits and otherwise serves no discernable nontax
business or financial purpose. The LIFO method is not currently designed, and
appears never to have been implemented, to achieve even its own avowed goal of
deferring only inflation-generated increases to inventory values. At the same time,
LIFO today is a significant source of economic distortions because it both privileges
investment in some asset classes over others and encourages tax-motivated
physical inventory management practices.
Proponents of the LIFO status quo argue that eliminating the ability of taxpayers to
rely on LIFO inventory accounting is a veiled tax
increase. (That argument of course
implicitly acknowledges that LIFO accounting is not merely a deferral, but rather a
permanent exemption from tax.) The response is that repealing LIFO would
"increase" a business enterprise's taxes only in the sense that eliminating any
special-interest tax break is described as a "tax increase" by those firms threatened
by the loss of their preferential treatment. LIFO accounting is inconsistent with a
principled income tax and simply creates tax forgiveness, largely concentrated in a
handful of companies and industries.
Among the themes that the President's Advisory Panel on
Federal Tax Reform
identified as having guided their deliberations:
Tax provisions favoring one activity over another or providing targeted tax
benefits to a limited number of taxpayers create complexity and instability,
impose large compliance costs, and can lead to an inefficient use of resources.
A rational system would favor a broad tax base, providing special
treatment only
where it can be persuasively demonstrated that the effect of a deduction,
exclusion, or credit justifies higher taxes paid by all taxpayers.
In his closing statement at the June 13 hearing, Finance Committee Chair Chuck
Grassley, R-Iowa, reiterated those basic ideas and outlined the benefits of the
undertaking:
Beyond trying to improve today's code, the discussion about issues such as tax
expenditures and fundamental problems with the tax system point the way for
thinking about tomorrow's tax code. The comments we have heard calling for
lowering the rates, broadening the base, and simplifying the tax code are good
goals that should guide our work as we consider corporate tax reform.
Achieving these goals of tax reform will not only make the code fairer and more
efficient, but it will also provide fiscal benefits to the budget. But of perhaps
greatest importance, we've heard today that a system of lower rates, broader
base and simplification will increase our nation's competitiveness in attracting
capital for new and better jobs
.
Grassley reiterated those themes in his closing statement at a recent hearing on
business
tax issues, and added an observation on the difficulties of the political
process:
Tax reform will take a bipartisan, national consensus. I think the consensus is
there that the business tax system is in desperate need of reform. But we need
to start building consensus on how to do it. The theme of lowering rates and
broadening the base is easy to agree with in theory. The tough part will be
figuring out how low and how broad. This committee will
continue down the path
of tax reform. This hearing sets the stage for future hearings that will examine
specific aspects of business tax reform in greater depth as we work toward
reforming the tax code.
The economic advantages of lower tax rates are well known, as are the distortions
that follow from various features of the code that provide narrow benefits to a select
class of taxpayers. There is a persuasive case for repealing the LIFO method of
inventory accounting for tax purposes in the context of broad-scale corporate tax
reform, based on income tax policy norms, fundamental fairness to all business
taxpayers, revenue considerations, and the failure of LIFO's tax largesse to be
restricted to its own purported objectives. Phrased differently, if we cannot succeed
in liquidating LIFO, what hope do we have of ever getting serious about
fundamental business tax reform?
Edward D. Kleinbard is a lawyer in private practice in New York City. George
A. Plesko is an associate professor of accounting at the University of
Connecticut. Corey M. Goodman is a third-year law student at New York
University School of Law. This article is based on the testimony of Kleinbard
and Plesko before the Senate Finance Committee on June 13, 2006, along
with their published replies to Questions for the Record submitted to them
after that hearing.
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