Repeal the “LIFO” and “Lower of Cost or Market” Inventory Accounting Methods

CBO periodically issues a compendium of policy options (called Options for Reducing the Deficit) covering a broad range of issues, as well as separate reports that include options for changing federal tax and spending policies in particular areas. This option appears in one of those publications. The options are derived from many sources and reflect a range of possibilities. For each option, CBO presents an estimate of its effects on the budget but makes no recommendations. Inclusion or exclusion of any particular option does not imply an endorsement or rejection by CBO.

Billions of Dollars 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2019-
Change in Revenues 6.5 13.0 13.0 13.0 7.0 1.0 1.1 1.1 1.1 1.1 52.5 57.9

Source: Staff of the Joint Committee on Taxation.
This option would take effect in January 2019.


To compute its taxable income, a business must first deduct from its receipts the cost of purchasing or producing the goods it sold during the year, also known as the cost of goods sold. Most companies calculate the cost of the goods they sell in a year by adding the value of the inventory at the beginning of the year to the cost of goods purchased or produced during the year and then subtracting from that total the value of the inventory at the end of the year. To determine the value of its year-end inventory, a business must distinguish between goods that were sold from inventory that year and goods that remain in inventory. The tax code allows firms to choose from among several approaches for identifying and determining the value of such goods.

Firms can value items in their inventory on the basis of the cost of acquiring those goods. There are several approaches for assigning a cost to an item of inventory. To itemize and value goods in stock, firms can use the "specific identification" approach, which requires a detailed physical accounting in which each individual item in inventory is tracked and is matched to its actual cost (that is, the cost to purchase or produce that specific item). Other approaches do not require a firm to track each specific item of inventory. One alternative approach—"last in, first out" (LIFO)—permits them to assume that the last goods added to the inventory were the first ones sold. Under that approach, the value assigned to goods sold from inventory should approximate their current market value (that is, the cost of replacing them). Yet another alternative approach—"first in, first out" (FIFO)—is based on the assumption that the first goods sold from a business's inventory were the first to be added to that inventory.

Firms that do not use the LIFO approach to assign costs can value inventory using the "lower of cost or market" (LCM) method. The LCM method allows firms to use the current market value of an item (that is, the current-year cost to reproduce or repurchase it) in their calculation of year-end inventory values if that market value is less than the cost assigned to the item. In addition, businesses can qualify for the "subnormal goods" method of inventory valuation, which allows a company to value inventory below cost if its goods cannot be sold at cost because they are damaged or flawed.

In 2013, businesses valued their combined year-end inventory at more than $2.1 trillion, according to the Internal Revenue Service. Corporations and partnerships held 98 percent of that inventory. Among the 1.6 million corporations and partnerships reporting information on inventory valuations, almost all used a cost-based method to value at least some portion of their inventory, approximately one-third made use of the LCM method for at least some goods, and more than 7,000 indicated that they had designated some inventory as subnormal goods. The LIFO approach was used by about 12,000 businesses to value approximately $290 billion of inventory.


This option would eliminate the LIFO approach to identifying inventory, as well as the LCM and subnormal-goods methods of inventory valuation. Businesses would be required to use either the specific-identification or the FIFO approach to account for goods in their inventory and to set the value of that inventory on the basis of cost. Those changes would be phased in over a period of four years.

Effects on the Budget

If implemented, the option would increase revenues by a total of $58 billion from 2019 through 2028, the staff of the Joint Committee on Taxation estimates.

The annual increase in revenues would be substantially larger from 2019 through 2023 than over the remainder of the 10-year period. That pattern reflects the effects of the option on the valuation of existing inventory. Companies that use approaches that would be eliminated by this option to identify inventory generally end up with lower taxable profits than they would using other approaches. Switching to another approach would force companies to revalue their existing inventory. That would cause a relatively large increase in taxable income during the four years over which the change was phased in and one additional year, because of variation in the timing of the financial year among companies. After the revaluation of existing inventory has occurred, the effect on revenues would be relatively small because companies could use only the specific-identification or FIFO approach to value their inventory going forward.

The estimate for this option is uncertain because it relies on the Congressional Budget Office's 10-year projections of corporate profits, investment, and inflation, which are inherently uncertain. In addition to those economic factors, the estimate depends on projections of firms' choices of inventory-valuation approaches. Those choices are also uncertain.

Other Effects

The main argument for this option is that it would align tax accounting rules with the way businesses tend to sell their goods. Under many circumstances, firms prefer to sell their oldest inventory first to minimize the risk that the products will become obsolete or damaged while in storage. In such cases, allowing firms to use alternative approaches to identify and value their inventories for tax purposes allows them to reduce their tax liabilities without changing their economic behavior. Under the LIFO approach, companies defer taxes on real (inflation-adjusted) gains when the prices of their goods are rising relative to general prices. Firms that use the LIFO approach can value items sold out of inventory on the basis of costs associated with newer—and more expensive—items when, in fact, the actual items sold may have been acquired or produced at a lower cost at some point in the past. By deducting those higher costs as the cost of production, firms can defer paying taxes on the amount their goods have appreciated until those goods are sold.

Another argument for this option is that the LCM and subnormal-goods methods of inventory accounting treat losses and gains asymmetrically by allowing firms to immediately recognize losses in the value of inventory but not requiring them to recognize gains. The LCM method will reduce the value of a business's year-end inventory if the market value of any item in the inventory is less than its assigned cost. Similarly, the subnormal-goods method of inventory valuation allows firms to immediately deduct the loss in a good's value, lowering the value of their year-end inventory. In either case, that lower value increases the deduction for the cost of goods sold and reduces taxable income. In effect, those methods allow firms to immediately deduct from taxable income the losses they incur from the decline in the value of their inventory without requiring them to include gains in the value of their inventory in taxable income.

An argument against this option is that the LIFO approach limits the effects of inflation on taxable income. When items sold from inventory are valued on the basis of past costs, price increases that occur between the time the inventory is purchased and the time its value is assessed raise taxable income. That effect tends to be greater under the FIFO approach than the LIFO approach because the latter values items sold from inventory using the purchase prices of more recently acquired goods, thus deferring the effects of inflation on taxable income. However, other elements of the corporate income tax also treat gains that are attributable to inflation as taxable income.

Another argument against this option is that the LCM and subnormal-goods methods of inventory valuation allow the value assigned to inventory to better reflect real changes in the value of underlying assets.