Friday, February 24, 2006

Not on Your LIFO: Stealth Taxes on Oil

These pages have reflected opposition to a so-called “windfall profits tax” on oil company profits. The basic argument goes like this: Oil companies take risks to produce a valuable commodity, which we need. Prices for oil vary, meaning that firms have lean and fat years. Singling out the fat years for special confiscatory taxes disrupts the incentive structure for production, and that is a bad thing.

Most people understand this intuitively: raising tax rates on a specific industry may not be good for the long-term economic health of that industry. Higher taxes could perhaps produce a desirable social result, resulting in less production of something you don’t want. (For example, taxing the pornography industry or cigarettes might mean less output.) But I don’t know of any politician who really wants to restrict the supply of oil and to raise those prices further. (Unless, of course, you want to go back to living very simply in an idealistic way – and good luck with that.)

If I have kept you this far, you are wondering when the LIFO pun comes in. I happen to be one of the few professors who has written a law review article on LIFO (covering 70 pages in the Florida Tax Review). How could there be that much to say about LIFO? Well, it is deep, man.

For those who don’t want to read through my article, here’s the problem brewing in Washington. Despite musings about a windfall profits tax, Congress did not choose to raise tax rates on big oil. However, the Senate has included a provision that will essentially do the same thing. Instead of increasing the rate, they will expand the tax base by raising the reportable profits.

Can Congress really do that (i.e., raise profits by the stroke of a pen)? If they really could, I wish they would pass laws requiring higher profits for all corporations. But of course they can’t raise real profits, but they can raise the profits that are reported for tax purposes. In this case, they are reducing the cost of goods sold for large oil companies by effectively reducing their LIFO reserves.

To explain, when oil goes up, the replacement cost of oil goes up, too. Oil companies that purchase inventories can use the LIFO method to match the costs of higher recent purchases against current sales, thus lowering taxable income. For those dealing in an inflationary environment, this is important. They have inventory costed at lower historical rates, reflecting the halcyon days of $12 oil, for example.

To illustrate, suppose my inventory consists of one barrel that I bought years ago at $20. I am able to sell it at $60. However, if I have buy another inventory to maintain my inventory level, I have to pay $60. Have I really made any money on this sale, when I would have to use all the proceeds to buy the same thing I had at the start? The LIFO method says no by allowing the taxpayer to match the $60 cost of the current inventory with the current sales revenue. In effect, you sold the last barrel you purchased. Overall, this produces a more accurate measure of income, and this method is widely adopted in industries that have experienced price increases in their inventory stock.

Senate Bill 2020 includes section 561, which essentially raises the value of existing LIFO layers in the inventory of large oil companies. (Layers arise from the additions to inventory each taxable year. The current cost minus the cost of that layer is effectively a form of deferred future income that would be realized when the inventory is liquidated.)

The Treasury Department has warned that the President will veto a bill with this provision. However, that bill may have lots of other goodies that people want. Before we are all done, it might even include permanent relief for dividends and capital gains or an AMT fix. It will be interesting to monitor whether this provision sticking it to big oil will survive or not if it is attached to something else the President wants badly. I’m not predicting, but this could get interesting.


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