On October 21, fourteen Senators, including nine Republicans and five Democrats, sent a letter to Treasury Secretary Jacob Lew pleading to save a business tax break known as last-in, first-out (LIFO) accounting, which both President Obama and Republican House Ways and Means Chairman Dave Camp have proposed to repeal as part of tax reform. Over 100 members of the House sent a similar letter to Camp in May. Here’s why defenders of LIFO are wrong.
LIFO is an inventory accounting method that allows some businesses to make their income for tax purposes look smaller than it otherwise would. We tend to think of profit this way: A company creates or purchases products at a cost of $90 and sells them for $100, resulting in a profit of $10. But consider a company that has built up an inventory of, say, barrels of whiskey at different points in time. The barrels it created or purchased five years ago may have cost $80, while those obtained this year cost $90. LIFO allows the company to tell the IRS that the barrels it sold today for $100 were those it most recently obtained (resulting in a $10 profit) rather than those it obtained five years ago (which would result in a profit of $20).
President Obama has proposed to repeal LIFO in his budget plans. Dave Camp, who will be retiring from Congress at the end of this year, included repeal of LIFO in the tax reform plan he released in February.
One reason is that LIFO is an unwarranted tax subsidy. When corporations that use LIFO report profits to their shareholders, they use normal accounting, not LIFO. In the example above, the company would tell shareholders that it made a profit of $20, so why should it be allowed to tell the IRS that it made a profit of just $10?
A second reason is that LIFO complicates tax and accounting rules. A third reason is that LIFO is not permitted under the International Financial Reporting Standards that have been adopted by several countries to streamline the rules for multinational companies, and thus is an obstacle to adoption of these rules by the United States.
The letter from the fourteen Senators supporting LIFO includes a couple of misleading statements. For example, the letter claims that “one of the most troubling effects of the proposed reform is the retroactive tax. If this reform is passed, the penalty to the businesses that used LIFO could extend decades into the past, forcing companies to pay off the ‘reserve’ to which they had legally been entitled.”
When supporters of LIFO talk about “LIFO reserves,” that’s a euphemism for untaxed profits. Returning to the example above, the company that has really profited $20 from selling a barrel of whiskey but is allowed under LIFO to tell the IRS it only had $10 of profit has a “reserve” of $10. In theory, the tax on this reserve is only being deferred, given that the goal of such a business is to sell all of its inventory eventually.
The letter goes on to state that subjecting these “reserves” to normal accounting and tax rules would be a “retroactive” tax increase. Because the idea of a retroactive tax increase seems unfair to most people, opponents of taxes have stretched the term “retroactive” to apply to any tax increase they want to stop. But in this case, the new rules proposed by Obama and Camp would apply to sales going forward. What would change is that a company would use normal accounting rules and assume that it has sold its oldest inventory, rather than its newest inventory. If one thinks of the difference between LIFO and the normal accounting rules as “reserves,” then it is true that companies will have to pay taxes they have deferred on these reserves as companies continue to earn profits from sales going forward.
But a retroactive tax on profits would, in contrast, be something like an increase in tax rates applied to previous years’ income so that additional taxes must be paid this year for income earned in the past — even for a company that has no profits at all this year.
Further, neither the Obama proposal nor the Camp proposal would come fully into effect immediately. Obama’s proposal would be phased in over ten years while Camp’s proposal would be phased in over four years starting in 2019.
LIFO should be repealed as Obama and Camp propose. But one should not overstate the importance of this reform. While Obama’s LIFO-elimination proposal would raise over $100 billion in the decade after enactment according to the Joint Committee on Taxation, it would raise considerably less revenue in years after that.
Because LIFO is largely a way to defer taxes rather than avoid them completely, repeal of LIFO mostly moves forward tax payments that would have otherwise occurred further out in the future. Some estimates suggest that in later years LIFO would raise around only $2 billion a year. Of course, lawmakers have bickered over far less than that.