Candice Horbacz
The Tax Foundation has unveiled a critical new resource, Options for Reforming America’s Tax Code 3.0: A Policymaker’s Guide to Tax Reform Trade-Offs, providing an exhaustive analysis of 86 potential modifications to the U.S. tax system. This comprehensive guide, released amidst mounting concerns over national fiscal health, models the intricate economic, distributional, and revenue implications of each proposed change. Notably, 52 of these options are projected to significantly reduce federal budget deficits on a dynamic basis over the next decade, offering potential pathways to fiscal sustainability as annual deficits approach an alarming $2 trillion.
The imperative for tax reform has never been more pressing. The Congressional Budget Office (CBO) projects that federal debt held by the public will reach 116 percent of GDP by 2034, far exceeding any previous historical peak. This trajectory, driven by persistent deficits, necessitates a reevaluation of the nation’s revenue streams. Policymakers from both sides of the aisle are increasingly acknowledging the urgency of addressing these fiscal imbalances, and the tax code presents a primary lever for action. However, the path to reform is fraught with complexities, as different tax adjustments, even those yielding similar conventional revenue, can have vastly divergent impacts on the broader economy, often influencing economic growth, fairness, and administrative simplicity.
The Nuance of Tax Policy: Beyond Conventional Scoring
A central theme of the Tax Foundation’s guide is the critical distinction between conventional (static) and dynamic scoring. Conventional scoring estimates the revenue impact of a tax change assuming no alteration in economic behavior. Dynamic scoring, conversely, attempts to forecast how tax policy changes will influence economic activity—such as investment, employment, and consumption—and subsequently how these behavioral responses will affect overall tax revenue. This more holistic approach reveals that some tax increases, while appearing revenue-positive on paper, can stifle economic growth and employment, ultimately undermining their intended fiscal benefits. Conversely, reforms that broaden the tax base or enhance efficiency can raise substantial revenue with less detriment to the economy, or even stimulate growth.
The guide emphasizes adherence to core tax principles: simplicity, neutrality, transparency, and stability. A simpler tax code reduces compliance costs for individuals and businesses. Neutrality ensures that the tax system does not unduly favor one type of economic activity or investment over another, minimizing distortions. Transparency allows taxpayers to understand how their taxes are calculated and why certain policies exist. Stability provides certainty for long-term economic planning. These principles serve as a crucial framework for evaluating the trade-offs inherent in any tax reform proposal.
To illustrate these complex trade-offs, the Tax Foundation highlights five distinct revenue-raising options, each presenting unique challenges and opportunities for Congress.
1. Eliminating the Income Tax Exclusion for Other Employer Fringe Benefits (Option 32)
Current Landscape and Background:
Employer-provided fringe benefits, ranging from health insurance and retirement contributions to less common perks like on-site gym access, student loan payments, and employee discounts, have long enjoyed a privileged status under federal tax law. Unlike traditional wages and salaries, the value of many of these benefits is excluded from an employee’s taxable income. This exclusion was initially conceived to encourage certain behaviors, such as employer-sponsored healthcare and retirement savings, and to simplify administration. However, over time, the proliferation of various fringe benefits has created a complex and, arguably, non-neutral tax environment.
The non-neutrality arises because the tax code favors compensation received as certain benefits over direct wages. Consider two employees earning the same total compensation of $50,000. If one receives all of it as taxable wages, while the other takes $2,000 in tax-free fringe benefits, the latter pays less in taxes, despite having the same economic income. This creates an incentive for employers to offer, and employees to prefer, compensation in the form of tax-exempt benefits, potentially distorting labor markets and reducing the overall efficiency of the tax system.
Proposed Reform and Projected Impact:
Option 32 proposes to eliminate the income tax exclusion for these "other" employer fringe benefits, meaning their monetary value would be included in an employee’s taxable income. This reform would broaden the individual income tax base, aligning the tax treatment of these benefits more closely with wages and salaries. The Tax Foundation projects that this option would decrease the primary deficit by $396.8 billion from 2027 through 2036 on a dynamic basis.
Comparison and Broader Implications:
The guide contrasts this option with a significant increase in the top marginal individual income tax rate to 50 percent. While both aim to raise revenue, the impact on the economy differs substantially. Raising the top marginal rate to 50 percent would result in a much larger decrease in Gross Domestic Product (GDP) and a greater reduction in work incentives. This is because higher marginal rates directly discourage productive economic activity by reducing the reward for additional labor and investment.
Eliminating fringe benefit exclusions, by contrast, broadens the tax base without increasing marginal rates on productive activity. This approach leads to a more neutral and transparent tax code, allowing the economy to allocate resources more efficiently. While popular among employees and employers who currently benefit from the exclusion, its repeal could face political opposition from various industry groups and employee advocacy organizations. However, proponents argue it would create a fairer system where all forms of compensation are treated more equally, reducing distortions and potentially allowing for lower overall tax rates in the future.
2. Repealing the Low-Income Housing Tax Credit (LIHTC) and the New Markets Tax Credit (NMTC) (Option 76)
Current Landscape and Background:
The Low-Income Housing Tax Credit (LIHTC), established in 1986, and the New Markets Tax Credit (NMTC), introduced in 2000, are two of the federal government’s most significant tools for incentivizing specific types of development. LIHTC provides tax credits to developers of affordable rental housing, aiming to increase the supply of housing for low-income individuals. The NMTC stimulates private investment in distressed communities by offering credits for equity investments in Community Development Entities (CDEs). Both programs have garnered bipartisan support over the years, lauded for their stated goals of promoting housing and economic development in underserved areas.
However, these credits have also faced considerable scrutiny from nonpartisan policy experts and government watchdogs. Criticisms often center on their complexity, administrative burden, and perceived inefficiency. The Government Accountability Office (GAO) and other researchers have pointed to the high cost per unit of housing delivered through LIHTC and its effectiveness in reaching those most in need. Similarly, the NMTC has been criticized for its opaque nature and the difficulty in definitively proving its additionality—that is, whether the investments would have occurred without the credit. The complex structure of these credits often results in a significant portion of the subsidy being absorbed by administrative costs, legal fees, and developer profits, rather than solely benefiting the intended recipients.
Proposed Reform and Projected Impact:
Option 76 proposes the outright repeal of both the LIHTC and NMTC. This action would broaden the business tax base by eliminating these specific tax expenditures. On a dynamic basis, the Tax Foundation estimates that repealing these credits would decrease the primary deficit by $202.7 billion from 2027 through 2036.
Comparison and Broader Implications:
The guide compares this repeal to capping the business state and local tax (SALT) deduction. While both actions broaden the tax base, their economic consequences differ. Capping the business SALT deduction is projected to result in a much larger decrease in GDP and a greater loss of jobs. This is because the SALT deduction is a widely claimed deduction for businesses, and its restriction would impose a broader tax increase on a larger segment of the economy.
Repealing specific, targeted tax credits like LIHTC and NMTC, which are often criticized for their inefficiency and complexity, can raise substantial revenue with less collateral damage to the overall economy. While the repeal would undoubtedly face strong opposition from affordable housing advocates, community developers, and the financial institutions that facilitate these investments, proponents argue that a more direct and transparent subsidy mechanism might achieve the same policy goals more efficiently. This option highlights the trade-off between targeted incentives for social goals and the broader principles of tax neutrality and economic efficiency.
3. Eliminating the Income Tax Exclusion for Municipal Bond Interest (Option 29)
Current Landscape and Background:
A long-standing feature of the U.S. tax code, dating back to the inception of the permanent income tax in 1913, is the exclusion of municipal bond (muni bond) interest from federal income tax. This provision allows state and local governments to issue bonds at lower interest rates than they would otherwise have to pay, as investors are willing to accept a lower yield in exchange for tax-exempt income. The exclusion effectively provides an indirect federal subsidy to state and local governments, helping them finance public projects such as infrastructure, schools, and hospitals.
While widely supported by state and local governments and their bond investors, this exclusion violates the principle of a neutral tax code. It favors investment in municipal bonds over other types of savings vehicles, such as corporate bonds or taxable federal bonds. This distortion can lead to an inefficient allocation of capital across the economy, as investment decisions are influenced by tax advantages rather than purely economic returns. It also creates a revenue loss for the federal government, essentially subsidizing state and local activities without direct budgetary appropriation or oversight.
Proposed Reform and Projected Impact:
Option 29 proposes to eliminate the income tax exclusion for municipal bond interest, meaning interest earned on these bonds would become taxable at the federal level, similar to most other forms of investment income. On a dynamic basis, this option is projected to decrease the primary deficit by $155.2 billion from 2027 through 2036.
Comparison and Broader Implications:
The Tax Foundation compares this option to the complete elimination of the state and local tax (SALT) deduction. Both the muni bond interest exclusion and the SALT deduction indirectly subsidize state and local government spending, but their economic impacts differ. Eliminating the SALT deduction is projected to cause more economic harm because it would increase marginal tax rates on labor income, pass-through business income, and investment in owner-occupied housing. The SALT deduction, especially after its $10,000 cap under the Tax Cuts and Jobs Act (TCJA) of 2017, largely affects higher-income taxpayers in high-tax states.
Removing the muni bond interest exclusion, while also impacting wealthier investors and potentially increasing borrowing costs for state and local governments, does so by broadening the investment income tax base rather than directly increasing marginal rates on labor or business income. State and local governments would likely protest this change vehemently, arguing it would raise their borrowing costs and hinder their ability to fund essential public services. However, proponents would contend that it creates a more neutral investment landscape and forces state and local governments to bear the full cost of their borrowing, potentially leading to more fiscally disciplined decision-making.
4. Tightening the Limitation on Itemized Deductions (Option 24)
Current Landscape and Background:
Itemized deductions allow taxpayers to reduce their taxable income by claiming specific expenses, such as mortgage interest, charitable contributions, and state and local taxes (subject to the $10,000 cap). The "One Big Beautiful Bill Act of 2025," a hypothetical but illustrative piece of legislation referenced in the guide, established a new limit on itemized deductions, effective from 2026. This limit caps the value of itemized deductions at 35 percent for taxpayers in the top (37 percent) tax bracket. This means a $10,000 deduction for a top-bracket taxpayer would result in a $3,500 tax cut (35% of $10,000) rather than the full $3,700 (37% of $10,000) they would otherwise receive.
This existing limitation serves to broaden the tax base by reducing the effective subsidy provided by itemized deductions, particularly for high-income earners. It also marginally encourages some taxpayers to opt for the simpler standard deduction over the complexities of itemizing, aligning with the principle of simplicity.
Proposed Reform and Projected Impact:
Option 24 proposes to further tighten this cap on itemized deductions, reducing it to 28 percent. This would further limit the tax benefit derived from itemizing for top-bracket taxpayers. On a dynamic basis, this option is projected to decrease the primary deficit by $139.0 billion from 2027 through 2036.
Comparison and Broader Implications:
This option is compared to taxing capital gains and dividends at ordinary income tax rates. Both options are primarily targeted at high-income taxpayers. However, tightening the overall cap on itemized deductions broadens the tax base by reducing the value of specific deductions, whereas taxing capital gains and dividends at ordinary rates significantly increases the marginal tax rate on investment income.
The Tax Foundation’s modeling indicates that tightening the itemized deduction cap is less damaging to the economy than increasing capital gains and dividend tax rates. Higher taxes on capital gains and dividends can discourage investment, savings, and entrepreneurship, leading to a reduction in capital formation and economic growth. While politically popular among some who seek to increase taxes on the wealthy, such policies can have significant negative effects on the broader economy. Tightening deduction limits, while still facing opposition from those who benefit from current deductions (e.g., homeowners, charities), represents a more base-broadening approach that can raise revenue with fewer economic distortions.
5. Introducing a Vehicle Miles Traveled Tax (VMT) (Option 79)
Current Landscape and Background:
The Highway Trust Fund (HTF), established in 1956, is the primary federal mechanism for funding interstate roads, bridges, and highways. Its main funding source is the federal gas tax, which has remained unchanged at $0.184 per gallon since 1993. Over the past three decades, inflation has eroded the purchasing power of the gas tax, while the cost of road maintenance and the nation’s infrastructure needs have steadily risen. Consequently, the HTF has faced persistent deficits and projected long-run shortfalls.
Adding to this fiscal challenge is the increasing adoption of electric, hybrid, and other clean energy vehicles. These vehicles, despite contributing to road wear and tear, pay little to nothing in gas taxes, exacerbating the HTF’s funding crisis. Heavy vehicles, such as tractor-trailers, also contribute disproportionately to road degradation compared to their gas tax contributions. The current funding model is increasingly unsustainable and inequitable.
Proposed Reform and Projected Impact:
Option 79 proposes a fundamental shift in highway funding: repealing the federal gas and diesel taxes and instituting a Vehicle Miles Traveled (VMT) tax, adjusted by vehicle weight. Under this model, the average passenger vehicle would pay approximately 0.9 cents per mile, while the average freight vehicle would pay around 10.6 cents per mile. This weight-adjusted VMT tax aims to create a more equitable system where users pay based on their road usage and the wear and tear they inflict. On a dynamic basis, this option is projected to decrease the primary deficit by $133.7 billion from 2027 through 2036.
Comparison and Broader Implications:
The guide compares this option to a simpler increase in the federal gas tax from $0.184 to $0.28 per gallon. While the federal gas tax increase might raise more revenue over a 10-year window, it is also projected to lead to more significant job losses. This is partly because a gas tax increase disproportionately affects lower-income individuals and those in rural areas with longer commutes, and it does not address the growing problem of non-gasoline vehicle usage.
Over a longer budget horizon, the VMT tax is presented as a more sustainable solution to HTF solvency concerns, particularly as electric vehicle adoption continues to grow. It aligns with the "user pays" principle more effectively than a declining gas tax base. Implementing a VMT tax, however, faces significant practical and political hurdles, including privacy concerns related to tracking vehicle mileage, the technological infrastructure required for collection, and public acceptance of a new tax mechanism. Despite these challenges, many transportation experts view VMT as the most viable long-term solution for funding road infrastructure in an era of increasing fuel efficiency and electrification.
The Broader Challenge of Tax Reform
The Tax Foundation’s Options for Reforming America’s Tax Code 3.0 serves as a stark reminder that all tax policies involve intricate trade-offs. As federal debt and deficits continue their upward trajectory, exceeding historic norms, the decisions policymakers make regarding the tax code will have profound and lasting consequences. The guide underscores that not all revenue-raising measures are created equal.
Congress must meticulously weigh core tax principles—simplicity, neutrality, transparency, and stability—alongside the projected economic effects of each reform option. The choice between broadening the tax base and increasing marginal tax rates, or between continuing targeted tax expenditures versus repealing them, represents fundamental philosophical differences in tax policy. The imperative is to pursue reforms that not only address the immediate fiscal crisis but also foster long-term economic growth, fairness, and a more robust and resilient national economy. The document itself is a valuable, objective tool to help policymakers navigate these complex choices, rather than endorsing or opposing specific options. Ultimately, the future economic health of the United States hinges on informed, principles-based tax reform.
