Proposals to eliminate LIFO would raise business taxes in two ways. First, a business would see higher future taxes as they are unable to use LIFO to protect themselves from rising inventory costs. Second, they would be required to pay taxes on their existing "LIFO Reserves."
This second tax is especially troubling for companies that have used LIFO for a long period of time. To understand how the combination of time and inflation can create a large LIFO reserve, consider the following example. An S corporation maintains a consistent inventory of 10 units. Every year, the business uses 10 units for production and buys ten units to replace them. Units cost $1 in year one and inflation is 3 percent per year.
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The following conclusions are made clear from the example.
- In an inflationary environment, LIFO enables the business to match up its current inventory costs with its current income, producing a more accurate picture of its annual income.
- Even mild inflation results in the LIFO reserve exceeding 20 percent the businesses' inventory value in less than 10 years.
- The longer the business uses LIFO, the larger its reserves will be relative to its inventory. In year 25, the LIFO reserve is more than 50 percent of the business' inventory value--again, under an assumption of 3 percent inflation.
If LIFO were repealed, these reserves would be taxed at rates up to 35 percent, even though the reserves reflect nothing more than the impact of economic inflation on the value of the business' inventory over 10 years.
It is important to note that LIFO reserves are an accounting entry. They do not reflect real assets and, as this example shows, they can and do reflect illusory gains caused by economic inflation. Taxing businesses on the size of their LIFO reserves is both burdensome and unfair.
