Inflation Tax and LIFO Accounting
Americans concerned with their level of taxation may be overlooking a significant but hidden form of taxation: inflation.
This may be difficult to grasp because inflation does not resemble other taxes such as income tax or sales tax.
Additionally, money lost due to inflation does not appear to go directly to the government.
Finally, the elected government does not mandate inflation like they do other taxes.
So how is inflation a form of taxation? Consider the following example.
First, let's say that in the year 2000 the cost of an Accounting textbook is $100.
In 2010, that textbook costs $110.
A student buying this textbook in 2010 is paying $10 that would not have to have been paid in 2000 as a result of inflation.
What makes this $10 increase in price a form of taxation is the fact that the Federal Reserve, a part of the government apparatus, affects the inflation rate by controlling the money supply.
When the Federal Reserve makes more money available, this results in higher prices for consumers which although hidden should be considered a tax.
This phenomenon is known as inflation tax.
Some would argue that inflation affects the currency uniformly, so the increase in prices due to inflation is accompanied by an increase in income, but this is not correct.
To continue the example from above, let us say that the student buying this textbook has been saving up for school since 2000.
The money that was invested in 2000 to cover school costs is worth less in 2010.
So while the student's income may be higher in 2010, any money spent from their savings will be subjected to this invisible tax.
Inflation tax affects all individuals and businesses, particularly those with money based primarily in cash.
Cash is most affected because unlike other investments, it does not have the opportunity to grow.
So stuffing money under a mattress may protect from thieves, but it does not protect from inflation.
As a result, some businesses choose to use LIFO (Last In First Out) accounting as a method to stem inflation.
The basic principle behind LIFO accounting is summed up in its name.
The inventory items that were purchased most recently (the last in) are sold first in an attempt to keep up with inflation.
Let's examine how this works in closer detail.
To continue the previous example, remember that Accounting textbooks cost $100 in 2000 and $110 in 2010 as a result of inflation.
This increase in price does not only affect the student buying the textbooks, it also affects the business that is selling the textbooks to the student.
Remember, the $10 increase was not the bookstore's markup - they do not see this as profit.
Instead, the bookstore is also affected by inflation and, like the students; they pay more for these books in 2010 than 2000.
What LIFO does is match inflation as best as possible.
By selling the books that were purchased most recently (and likely paid the most money for), the business is able to stem its loss from inflation tax.
To put this in more concrete terms, let's say that the Campus Bookstore paid $80 for Accounting textbooks in 2000 and $90 in 2010.
In either case, the store sells textbooks at a price that is $20 higher than they pay.
However, if the store had a book in its inventory that was purchased in 2000 (for $80) which it sold in 2010 (for $110).
The business will be taxed for their entire $110 sale, even though $10 of this comes directly from inflation.
The underlying principle of LIFO accounting is that this can be avoided by selling the items that were most recently added to inventory, not giving inflation much time to take effect and do its damage.
While in the Campus Bookstore example, the money saved through LIFO accounting may not seem material, it certainly adds up at larger firms.
In times of inflation, LIFO should be something to consider as a means to avoid inflation tax.
While inflation affects all of society, many are unaware of its painful effects on our currency.
What many people do not realize is that inflation is indeed a form of taxation.
While it does not come out of a person's paycheck or get tacked on to a sales bill, inflation is an indirect form of taxation that does have a very concrete cost.
Businesses and investors alike should familiarize themselves with the deleterious effects of inflation tax and consider methods to avoid it, such as LIFO accounting.
This may be difficult to grasp because inflation does not resemble other taxes such as income tax or sales tax.
Additionally, money lost due to inflation does not appear to go directly to the government.
Finally, the elected government does not mandate inflation like they do other taxes.
So how is inflation a form of taxation? Consider the following example.
First, let's say that in the year 2000 the cost of an Accounting textbook is $100.
In 2010, that textbook costs $110.
A student buying this textbook in 2010 is paying $10 that would not have to have been paid in 2000 as a result of inflation.
What makes this $10 increase in price a form of taxation is the fact that the Federal Reserve, a part of the government apparatus, affects the inflation rate by controlling the money supply.
When the Federal Reserve makes more money available, this results in higher prices for consumers which although hidden should be considered a tax.
This phenomenon is known as inflation tax.
Some would argue that inflation affects the currency uniformly, so the increase in prices due to inflation is accompanied by an increase in income, but this is not correct.
To continue the example from above, let us say that the student buying this textbook has been saving up for school since 2000.
The money that was invested in 2000 to cover school costs is worth less in 2010.
So while the student's income may be higher in 2010, any money spent from their savings will be subjected to this invisible tax.
Inflation tax affects all individuals and businesses, particularly those with money based primarily in cash.
Cash is most affected because unlike other investments, it does not have the opportunity to grow.
So stuffing money under a mattress may protect from thieves, but it does not protect from inflation.
As a result, some businesses choose to use LIFO (Last In First Out) accounting as a method to stem inflation.
The basic principle behind LIFO accounting is summed up in its name.
The inventory items that were purchased most recently (the last in) are sold first in an attempt to keep up with inflation.
Let's examine how this works in closer detail.
To continue the previous example, remember that Accounting textbooks cost $100 in 2000 and $110 in 2010 as a result of inflation.
This increase in price does not only affect the student buying the textbooks, it also affects the business that is selling the textbooks to the student.
Remember, the $10 increase was not the bookstore's markup - they do not see this as profit.
Instead, the bookstore is also affected by inflation and, like the students; they pay more for these books in 2010 than 2000.
What LIFO does is match inflation as best as possible.
By selling the books that were purchased most recently (and likely paid the most money for), the business is able to stem its loss from inflation tax.
To put this in more concrete terms, let's say that the Campus Bookstore paid $80 for Accounting textbooks in 2000 and $90 in 2010.
In either case, the store sells textbooks at a price that is $20 higher than they pay.
However, if the store had a book in its inventory that was purchased in 2000 (for $80) which it sold in 2010 (for $110).
The business will be taxed for their entire $110 sale, even though $10 of this comes directly from inflation.
The underlying principle of LIFO accounting is that this can be avoided by selling the items that were most recently added to inventory, not giving inflation much time to take effect and do its damage.
While in the Campus Bookstore example, the money saved through LIFO accounting may not seem material, it certainly adds up at larger firms.
In times of inflation, LIFO should be something to consider as a means to avoid inflation tax.
While inflation affects all of society, many are unaware of its painful effects on our currency.
What many people do not realize is that inflation is indeed a form of taxation.
While it does not come out of a person's paycheck or get tacked on to a sales bill, inflation is an indirect form of taxation that does have a very concrete cost.
Businesses and investors alike should familiarize themselves with the deleterious effects of inflation tax and consider methods to avoid it, such as LIFO accounting.
