Candice Horbacz
The Looming Fiscal Challenge and the Imperative for Tax Reform
The United States faces an unprecedented fiscal challenge. For years, federal spending has outpaced revenue, leading to persistent and growing budget deficits. The Congressional Budget Office (CBO) projects that annual deficits will remain near or above $2 trillion for the foreseeable future, driving the national debt to unsustainable levels. This trajectory threatens long-term economic stability, crowds out private investment, and limits the government’s ability to respond to future crises. Against this backdrop, the Tax Foundation’s latest report offers a timely and invaluable analysis, moving beyond partisan rhetoric to provide data-driven insights into how tax policy changes can impact the economy, income distribution, and government revenue.
The urgency of this situation is underscored by the fact that not all revenue-raising measures are created equal. While two different tax increases might generate similar amounts of revenue when scored conventionally (i.e., without accounting for behavioral changes), their broader economic impacts can vary significantly. Some reforms might inadvertently introduce greater complexity or inefficiency into the tax system, hindering economic growth and distorting market behavior. Conversely, others could simplify the tax code, enhance its neutrality, and foster a more robust economy while still addressing the deficit. The Tax Foundation emphasizes core tax principles—simplicity, neutrality, transparency, and stability—as essential benchmarks against which any proposed reform should be measured. A neutral tax code, for instance, minimizes distortions by treating similar economic activities or forms of income equally, allowing market forces rather than tax incentives to drive economic decisions.
The guide employs a sophisticated "dynamic scoring" methodology, which accounts for how changes in tax policy influence economic behavior, such as work, saving, and investment. This contrasts with "conventional scoring," which often assumes no change in economic behavior, thus potentially overestimating or underestimating revenue impacts. Dynamic scoring provides a more realistic assessment of policy trade-offs, revealing that some reforms, while appearing to raise less revenue conventionally, might be more economically beneficial in the long run.
The following five revenue-raising options from the Tax Foundation’s guide exemplify the complex trade-offs that Congress must meticulously consider when leveraging the tax code to mitigate federal debt and deficits.
1. Eliminating the Income Tax Exclusion for Other Employer Fringe Benefits (Option 32)
Background and Current Landscape:
Employer-provided fringe benefits represent a significant component of employee compensation in the U.S. economy. Unlike wages and salaries, many of these benefits are excluded from federal income taxation, a practice that has evolved over decades. While well-known examples include health insurance premiums and retirement plan contributions, a vast array of other "fringe" benefits also enjoy tax-free status. These can range from the seemingly minor, like on-site gym access or employee discounts, to more substantial provisions such as employer payments for student loans or dependent care assistance. The original intent behind many of these exclusions was often to encourage employers to provide specific benefits deemed socially desirable, such as health coverage or retirement savings, or to simplify administrative burdens for certain perks.
However, this widespread exclusion introduces a significant non-neutrality into the tax code. Consider two employees, both receiving $50,000 in total compensation. If one earns it entirely in taxable wages, while the other receives $48,000 in wages and $2,000 in tax-free fringe benefits, the latter pays less in federal income taxes. This creates an uneven playing field, favoring certain forms of compensation over others and distorting individual and employer choices. Employees might opt for fringe benefits they might not otherwise value as highly, simply because of their tax-advantaged status, rather than receiving an equivalent amount in taxable wages that could be spent more flexibly.
Proposed Reform and Economic Implications:
Option 32 proposes to eliminate the income tax exclusion for these "other" employer fringe benefits, meaning their value would be included in an employee’s taxable income. This reform would significantly broaden the individual income tax base, aligning the tax treatment of these benefits more closely with traditional wages and salaries. By doing so, it would enhance the neutrality of the tax code, reducing distortions in compensation structures and promoting a more transparent system where all forms of compensation are treated equitably.
On a dynamic basis, the Tax Foundation projects that this option would decrease the primary deficit by a substantial $396.8 billion from 2027 through 2036. This revenue generation comes with a relatively modest economic impact.
Comparison and Analysis:
The Tax Foundation compellingly contrasts this option with raising the top marginal individual income tax rate to 50 percent (from the current 37 percent for the highest earners). While a rate increase of this magnitude would also generate significant revenue, it is modeled to result in a much larger decrease in gross domestic product (GDP) and a more substantial reduction in work incentives. Raising marginal rates directly disincentivizes productive economic activities such as working, saving, and investing, leading to a smaller overall economic pie. Broadening the tax base by eliminating fringe benefit exclusions, on the other hand, can raise comparable amounts of revenue while inflicting considerably less damage on the nation’s economy. This illustrates a core principle of tax reform: it is generally more economically efficient to raise revenue by broadening the tax base (taxing more activities at lower rates) than by increasing marginal tax rates on a narrower base.
2. Repealing the Low-Income Housing Tax Credit and the New Markets Tax Credit (Option 76)
Background and Current Landscape:
The Low-Income Housing Tax Credit (LIHTC), established in 1986, and the New Markets Tax Credit (NMTC), created in 2000, are both federal tax credits designed to incentivize investment in specific areas. LIHTC is the largest federal program for creating and preserving affordable rental housing in the United States, providing tax credits to developers who build or rehabilitate housing for low-income tenants. NMTC encourages investment in low-income communities by providing a tax credit to investors who make equity investments in Community Development Entities (CDEs), which then use the capital to finance businesses and real estate projects in distressed areas. Both credits have enjoyed broad bipartisan support, often lauded for their roles in fostering housing and economic development in underserved communities.
However, despite their popular appeal and stated objectives, both credits have faced scrutiny from nonpartisan policy experts regarding their complexity and cost-effectiveness. The Government Accountability Office (GAO) and Congressional Research Service (CRS) have highlighted the intricate nature of these programs, which can lead to high administrative costs and potential inefficiencies. The LIHTC, in particular, has drawn criticism for its high cost per unit of affordable housing delivered and its potential inefficiency in reaching the neediest populations. Critics argue that a significant portion of the subsidy flows to developers and intermediaries rather than directly translating into lower housing costs for residents. Similarly, the NMTC has been questioned for the difficulty in precisely measuring its economic impact and ensuring that investments truly benefit the intended low-income communities.
Proposed Reform and Economic Implications:
Option 76 proposes the repeal of both the LIHTC and NMTC. This action would broaden the business tax base by eliminating these specific tax expenditures, treating the investments they incentivize in the same way as other business investments. By removing these targeted subsidies, the tax code would become more neutral, reducing distortions in capital allocation that might otherwise favor credit-eligible projects over potentially more economically efficient alternatives.
On a dynamic basis, this option is projected to decrease the primary deficit by $202.7 billion from 2027 through 2036.
Comparison and Analysis:
The Tax Foundation compares repealing these credits to capping the business state and local tax (SALT) deduction. The SALT deduction allows businesses (particularly pass-through entities) to deduct state and local taxes paid from their federal taxable income. While capping the business SALT deduction also broadens the tax base, the Tax Foundation’s model suggests it results 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 a necessary business expense, and capping it effectively raises the cost of doing business in high-tax states, potentially leading to significant economic dislocations.
Conversely, repealing the LIHTC and NMTC targets narrow and often inefficient business tax credits. While these credits serve specific social goals, their repeal, from a purely economic efficiency perspective, can raise substantial revenue with less overall economic damage compared to restricting a more fundamental deduction like SALT. This highlights another critical trade-off: broad-based deductions, even if they appear to reduce the tax base, might be more economically benign than highly targeted, complex credits that distort investment decisions. Proponents of LIHTC and NMTC would likely argue vigorously against repeal, citing the vital role these credits play in addressing housing shortages and stimulating development in underserved areas, suggesting that the social benefits outweigh the economic inefficiencies identified by critics.
3. Eliminating the Income Tax Exclusion for Municipal Bond Interest (Option 29)
Background and Current Landscape:
The tax exclusion for municipal bond (muni bond) interest is one of the oldest provisions in the U.S. tax code, dating back to the establishment of a permanent income tax in 1913. This exclusion means that interest income earned by investors from bonds issued by state and local governments is exempt from federal income tax (and often state and local taxes within the issuing jurisdiction). This provision effectively subsidizes state and local borrowing, allowing municipalities to issue bonds at lower interest rates than they would otherwise have to pay. For investors, the tax-free status makes muni bonds particularly attractive, especially to high-income individuals and institutional investors in higher tax brackets.
Over decades, the muni bond interest exclusion has garnered bipartisan support, primarily because it provides a significant financial advantage to state and local governments, enabling them to finance public infrastructure projects—schools, roads, bridges, water systems—at reduced costs. However, from a tax neutrality perspective, this exclusion represents a significant distortion. It favors one specific type of savings vehicle (muni bonds) over all other forms of investment, such as corporate bonds, Treasury bonds, or private sector investments, which are typically subject to federal income tax on their interest earnings. This non-neutrality can divert capital from potentially more productive private sector investments towards public projects, even if those private projects might offer a higher pre-tax return.
Proposed Reform and Economic Implications:
Option 29 proposes to eliminate the income tax exclusion for municipal bond interest. Under this reform, interest earned on muni bonds would be treated like interest from other taxable investments, included in an investor’s taxable income. This would broaden the individual income tax base and remove a long-standing non-neutrality.
On a dynamic basis, this option is projected to decrease the primary deficit by $155.2 billion from 2027 through 2036.
Comparison and Analysis:
The Tax Foundation compares this reform to the elimination of the entire State and Local Tax (SALT) deduction for individuals. Both the muni bond interest exclusion and the SALT deduction indirectly subsidize state and local government spending, albeit through different mechanisms. The SALT deduction allows individual taxpayers to deduct certain state and local taxes (property, income, or sales taxes) from their federal taxable income, effectively reducing their federal tax liability.
However, the economic impacts of eliminating these two provisions differ significantly. Eliminating the SALT deduction is modeled to cause more economic harm because it increases the effective marginal tax rates on labor income, pass-through business income, and investment in owner-occupied housing in high-tax states. This can disincentivize work and investment in those areas and potentially lead to outmigration. In contrast, while eliminating the muni bond exclusion would raise borrowing costs for state and local governments and likely face strong opposition from these entities, its direct impact on marginal rates for labor and broad investment is less severe than eliminating SALT. The debate would pit the fiscal health of state and local governments against the federal government’s need for revenue and the principle of tax neutrality.
4. Tightening the Limitation on Itemized Deductions (Option 24)
Background and Current Landscape:
The U.S. income tax system allows taxpayers to reduce their taxable income either by taking a standard deduction or by itemizing various deductions, such as those for mortgage interest, charitable contributions, and certain state and local taxes. Historically, these itemized deductions have been uncapped, meaning their full value could be subtracted from income. However, the "One Big Beautiful Bill Act of 2025" (a hypothetical legislative construct within the Tax Foundation’s model, representing a future tax bill) established a new limit on itemized deductions, effective from 2026. This new limit caps the value of itemized deductions at 35 percent for taxpayers in the top (37 percent) income tax bracket. This means that for a taxpayer in the 37 percent bracket, a $10,000 deduction, which would have previously resulted in a $3,700 tax cut (37% of $10,000), now only results in a $3,500 tax cut (35% of $10,000).
This initial cap was a step towards broadening the tax base and reducing the tax benefit disproportionately enjoyed by high-income earners from various deductions. It also, on the margin, encourages some taxpayers who might have previously itemized to opt for the simpler standard deduction, thereby streamlining tax compliance for a segment of the population.
Proposed Reform and Economic Implications:
Option 24 proposes to further tighten this cap on itemized deductions, reducing it from 35 percent to 28 percent for taxpayers in the top bracket. This would further reduce the tax benefit derived from itemized deductions for high-income earners, effectively increasing their taxable income.
On a dynamic basis, this option is projected to decrease the primary deficit by $139.0 billion from 2027 through 2036.
Comparison and Analysis:
The Tax Foundation compares tightening the itemized deduction cap to taxing capital gains and dividends at ordinary income tax rates. Both options are primarily targeted at high-income taxpayers, as they are the ones most likely to itemize deductions and to derive significant income from capital gains and dividends.
However, their economic effects differ. Tightening the overall cap on itemized deductions primarily broadens the tax base by reducing the value of certain deductions. While it reduces the after-tax return from activities like charitable giving or homeownership for high-income individuals, it does not directly increase marginal tax rates on labor or investment income broadly. In contrast, taxing capital gains and dividends at ordinary income tax rates would significantly increase the marginal tax rate on investment returns, which is generally considered more damaging to the economy. Higher taxes on capital gains can discourage saving, investment, and entrepreneurial activity, leading to reduced capital formation and slower economic growth. Therefore, from an economic efficiency standpoint, tightening the deduction cap is generally less damaging than raising marginal rates on capital income, even if both primarily affect higher-income taxpayers. This highlights the preference for base-broadening over rate-raising when seeking revenue.
5. Introducing a Vehicle Miles Traveled Tax (Option 79)
Background and Current Landscape:
The federal Highway Trust Fund (HTF), established in 1956, is the primary mechanism for funding interstate roads, bridges, and highways in the United States. Its main funding source has historically been the federal gas tax, an excise tax levied on gasoline and diesel fuel. However, this funding mechanism faces significant challenges. The federal gas tax has not been adjusted for inflation since 1993, meaning its real value has steadily eroded over three decades. Simultaneously, the costs of road maintenance, new construction, and the nation’s overall infrastructure needs have surged. This mismatch has led to persistent deficits in the HTF, threatening its long-term solvency.
A compounding challenge is the rapid adoption of electric, hybrid, and other clean energy vehicles. While these vehicles contribute to environmental sustainability, they pay little to nothing in federal gas taxes, despite utilizing and contributing to the wear and tear of the road infrastructure. This creates a fairness issue, as drivers of traditional gasoline-powered vehicles bear a disproportionate share of the funding burden. Furthermore, heavy vehicles, such as tractor-trailers, cause significantly more damage to roads but do not necessarily contribute proportionally more in gas taxes, especially as fuel efficiency improves across all vehicle types.
Proposed Reform and Economic Implications:
Option 79 proposes a fundamental shift in transportation funding: repealing the federal gas and diesel taxes and instituting a Vehicle Miles Traveled (VMT) tax, adjusted by vehicle weight. Under this system, drivers would pay a per-mile fee, with heavier vehicles paying a higher rate to reflect their greater impact on infrastructure. For example, the Tax Foundation models an average passenger vehicle paying about 0.9 cents per mile, while an average freight vehicle would pay approximately 10.6 cents per mile. This reform addresses the declining revenue problem by creating a more sustainable and equitable funding source for the HTF, linking contributions directly to road usage and impact, rather than fuel consumption.
On a dynamic basis, this option is projected to decrease the primary deficit by $133.7 billion from 2027 through 2036.
Comparison and Analysis:
The Tax Foundation compares the VMT tax to simply increasing the federal gas tax from its current $0.184 per gallon to $0.28 per gallon. While the gas tax increase would raise more revenue over the initial 10-year window, it is also modeled to lead to more significant job losses, as it directly increases the cost of fuel for all vehicles, including those used by businesses. Moreover, a gas tax increase would only offer a temporary reprieve for the HTF’s solvency issues, as it would still be vulnerable to inflation and the continued rise of fuel-efficient and electric vehicles.
The VMT tax, while potentially facing implementation challenges related to privacy concerns and technological infrastructure, offers a more robust and sustainable long-term solution. It directly addresses the issue of "free ridership" by electric vehicles and ensures that all road users contribute proportionally to infrastructure maintenance. Over a longer budget window, as electric vehicle adoption inevitably increases, the VMT tax is poised to become an increasingly vital and equitable funding mechanism for the nation’s transportation infrastructure, ensuring the HTF’s solvency for generations to come.
Big Picture: Navigating the Trade-Offs for a Sustainable Fiscal Future
The Tax Foundation’s "Options for Reforming America’s Tax Code 3.0" serves as a crucial guide for policymakers navigating the treacherous waters of rising federal debt and deficits. The analysis vividly illustrates that all tax policies involve trade-offs—between revenue generation, economic growth, distributional fairness, and administrative simplicity. The choices made today will have profound implications for the nation’s economic health and fiscal stability for decades.
As Congress contemplates future legislation, it must weigh these core tax principles—simplicity, neutrality, transparency, and stability—alongside the modeled economic effects of various reform options. Prioritizing base-broadening over marginal rate increases, for instance, often yields more economically efficient revenue generation. Scrutinizing the effectiveness and efficiency of targeted tax credits and exclusions, even those with popular support, can unlock significant revenue without disproportionately harming the broader economy. Finally, adapting tax systems to evolving economic realities, such as the shift to electric vehicles, is essential for long-term fiscal sustainability. The report underscores that thoughtful, data-driven tax reform is not merely about raising money, but about constructing a tax code that supports a dynamic, fair, and prosperous American economy.
