Tax Reform in 2025

The current United States Internal Revenue Code is completely broken because it is unfair, too complicated to be administered efficiently[1] and consistently fails to raise enough money to pay for programs approved by Congress.

Unfortunately, the Trump administration is promoting changes in the tax code that would make the situation worse by additional tax cuts and tax gimmicks, i.e., special treatment for tips, social security payments and other items which wouldfurther impact revenue collections and complicate an already enormous andunwieldy tax code.  

Federal expenditures in 2024 will be about $6.3 trillion and tax collections will be about $4.4 trillion, leaving a deficit of nearly $2 trillion.   Interest on the national debt is already$892 billion per year, which is more than the entire budget of the Department of Defense, and is projected to hit $1.7 trillion by 2034 because of risinginterest rates and continuing deficits.[2]

The current state of the tax code is mainly due to some political realities that have governed congressional action on tax legislation for decades, namely:

1.     Tax cuts are popular, but spending cuts to pay for them are not.

2.     Tax cuts without spending cuts have been justified by claims that the cuts will pay for themselves by promoting growth – a claim that is politically convenient butnot supported by much evidence.[3]

3.     Tax gimmicks, i.e., code provisions that treat some items of income or expense differently than others, are politically attractive because they benefit the politicians who propose them and the taxpayers who benefit from them while escaping the annual budget scrutiny that would apply to above-the-line subsidies.  They also allow the politicians who propose them to avoid being labeled as “big spenders” although the eventual impact of tax gimmicks on the budget may not be much different from above-the-line subsidies.  

4.     Budget deficits although damaging over time have been unimportant from a political standpoint because their consequences are mostly felt after the politicians who create them leave office.  

Trouble is, we are now at a point where the toxic effects of budget deficits are a current problem, where spending on debt service is so great that it will crowd out spending on other things, e.g., infrastructure, education, health care, defense, etc. which are critical to the national welfare.

Moving forward, what is needed is a new tax code which is (1) fair, (2) raises enough money to support government programs and (3) simple enough to reduce compliance costs to a reasonable level.

The initial focus of any serious tax reform effort should be to eliminate all gimmicks inthe tax code except any for which there are compelling policy justifications, and to sunset whatever gimmicks remain so that they can be subject to periodic Congressional review.  

The reason to start with gimmicks is that getting rid of them will promote all of the major objectives of tax reform at once. First, this will reduce the complexity of the tax code by treating all income in the same way  -- no one will need to figure out the difference between ordinary income and capital gains, because they will be taxed at the same rate.

Second, they will promote fairness because taxpayers with equal incomes will pay equal taxes regardless of how that income is derived. Homeowners who pay $3,500 per month in property taxes and mortgage interest will pay the same Federal income tax, all else being equal, as renters who pay $3,500 per month in rent.

Finally, eliminating the gimmicks is likely to raise substantial revenue, which as noted above is urgently needed to keep the deficit and national debt under control.

The Congressional Joint Committee on Taxation publishes an annual report which estimates the revenue cost to the Treasury of some of the leading tax gimmicks.  Some of the more expensive ones are:[1]

(a)  Preferential tax rates on capital gains ($265.1billion);

(b)  Exemption for employer-provided health insurance ($202.1billion)

(c)  Non-taxation of capital gains on inherited property ($57.9 billion);

(d)  Deduction for “qualified business income;” ($55.7 billion)

(e)  Allowance of itemized deductions for interest and property taxes on a principal residence($24.7 billion).

Whether there are substantial policy justifications for any of these gimmicks is questionable as discussed below.

Capital Gains

The traditional justification for preferential rates on capital gains has been that they promote growth by encouraging savings and investment and allow investors to move capital from low-yielding investments to others with better returns.

The author’s experience working with property owners is that capital gains taxes even at preferential rates prevent or discourage asset sales because owners know that they can pass their assets on to their heirs and never pay these taxes – the problem will go away because the heirs will receive a “stepped-up”cost basis equal to their value on the date of the owner’s death.  Elimination of this loophole would likely domore to promote capital mobility than any change in the rates.    

There is evidence that changes in capital gains tax rates produce some short-term effects – sales of capital assets go up for a short time after rates are reduced and go up just before higher rates are scheduled to go into effect.[1]  However, the long-term effects of rates on savings and investment are likely small, and most of the evidence suggests that rate reductions reduce tax revenue because they are not offset by substantial positive growth effects.[2]  

Preferential rates for capital gains also present major fairness issues, since the lion’s share of capital gains are reported by wealthy taxpayers.    According to the Tax Policy Center, the richest 1 percent of Americans reported anestimated 75 percent of all long-term capital gains in 2019, with the richest0.1 percent—people with annual incomes exceeding $3.8 million—bringing in more than half of all capital gains.[3]

Finally, preferential rates on capital gains are responsible for much of the complexity of the current tax code because lengthy code provisions are required to distinguish ordinary income from capital gains.  

For example, gains from the sale of depreciated property are “recaptured,” i.e., taxed as ordinary income to the extent of the depreciation – the rationale being that if depreciation was deductible against ordinary income, then the gain on a sale of the depreciated asset should also be ordinary income up to the amount of depreciation claimed.[4]  There are also elaborate rules and regulations which determine whether distributions from corporations and partnerships to their owners are taxable as capital gains or ordinary income.

In sum, preferential rates on capital gains add much complexity to the tax code, pose major fairness issues by taxing the wealthiest taxpayers at lower rates, and do not seem to do much to encourage savings and investment.  For all of these reasons, preferential rates on capital gains should be eliminated.

Non-taxation of capital gains on inherited property

As noted above, the current tax code provides that property acquired from the estate ofa decedent receives a “stepped-up” cost basis equal to its value on the owner’s date of death.  This means, for example that a property worth $1 million which the owner acquired for $200,000 can be sold by the heirs for $1 million without paying any capital gains tax, even though a sale the day before the owner’s death would have resulted in a taxable gain of $800,000.[1]  

This rule is different from the rule applicable to lifetime gifts, which is that the recipient of the gift takes the donor’s cost basis in the property.  For this reason, estate planning attorneys often advise against making lifetime gifts of appreciated property because they do not benefit from the stepped-up basis rule that applies to property passing through a decedent’s estate.

One policy rationale for the stepped-up basis rule is that it may be difficult to determine the owner’s cost basis if the property has been owned for many decades. However, historical basis reporting is already required for lifetime gifts, and the people making those gifts do not seem to have trouble coming up with basis numbers.  

Another rationale is, or may have been, that the government should not be able to levy estate taxes on decedents’ estates using fair market values while also collecting income taxes on gains when the estate’s assets are sold.  This problem if it is one could easily be dealt with by allowing a credit against capital gains taxes for any estate tax paid on a particular asset.  In any case, the vast majority of decedents’ estates are not currently subject to estate taxes.[2]

In summary, the stepped-up basis rule is counter-productive in terms of capital mobility in that it discourages current sales of assets and also results insubstantial revenue losses to the government. It is also unfair because it allows inheritors to avoid taxes that others would have to pay on the same amount of income.

Exemption for employer-provided health insurance

Current tax law provides that premiums paid by employers for health insurance on their employees are exempt from income and payroll taxes, so that employees who receive these benefits pay lower taxes than self-employed or unemployed persons who must pay for them with after-tax dollars.[3]  This rule has the effect of promoting employment-based health coverage, which isin itself problematic, has huge negative impact on tax revenue (currently over$200 billion per year) and has many other negative consequences.[1]  

For one, the rule grants a larger subsidy to employees who have more taxable income than entry-level employees who have less and who presumably need subsidies the most.  Second, the rule discriminates in favor of large employers, who unlike the small businesses that create most jobs, have the large HR departments necessary to administer complex health care programs.  Further, the subsidy distorts health care markets by increasing demand for “Cadillac” health care plans anddrives up costs.[2]  

In summary, there are no obvious policy justifications to subsidize employer-provided health insurance and a host of good reasons for the elimination of this gimmick.  The alternative would be a rule which taxes all employer-provided benefits as income, which from an economic standpoint they are, and which would treat employees the same for this purpose as taxpayers who are either not employed or self-employed.  

Qualified Business Income Deduction  

The “qualified business income” (“QBI”) deduction was added to the tax code by the 2017 Tax Cuts and Jobs Act, which reduced the corporate tax rate from 35% to21%, and has no policy rationale at all beyond giving the owners of small businesses conducted through partnerships and small business corporations a comparable tax break.

The QBI deduction is fundamentally unfair because it grants taxpayers who get their income from a business a 20% deduction which isn’t available to taxpayers with income from other sources, such as wages, rents, interest and dividends.  QBI also adds substantial complexity to the tax code because detailed rules are required to figure the deduction – to determine which businesses are “qualified,” to cap the deduction for “specified businesses” (basically lawyers, doctors, artists and other service businesses),to determine whether businesses under common ownership can or must be aggregated and so forth.

There is absolutely no evidence that this complex gimmick has produced any growth in the economy which even approaches its $55 billion annual cost to the government.  It is scheduled to sunset in 2025 and shouldbe allowed to disappear without further legislative action.

Itemized Deductions for Mortgage Interest and Real Property Taxes on a Personal Residence

This gimmick has been in the tax code since its inception and has developed loyal constituencies, i.e., homeowners who benefit from these deductions and real estate brokers who sell homes.  The stated rationale for these deductions usually is that they encourage home ownership and create various social benefits associated with home ownership.[1]

Problem is, it is not at all clear that the mortgage interest and property tax deductions in fact increase home ownership, nor is it clear that there are real social benefits arising from home ownership.[2]   What is clear is that these deductions are unfair because they result lower income taxes for homeowners than for renters, give bigger subsidies to owners of luxury homes than to entry-level owners and likely distort markets by driving home prices higher than they would otherwise be.[3]

The mortgage interest and property tax deductions are less costly in terms of lost revenue than they used to be because of changes made to the tax code in 2017,which increased the standard deduction, capped deductions for state and local taxes at  $10,000 and limited the amount of mortgage debt on which interest could be deducted to $750,000.  Prior to these changes the revenue loss from these deductions was over $66 billion per year, and could rise to that level again when the 2017 changes sunset in 2025.

All of these are good reasons for concluding that these deductions are not useful and should be eliminated from the tax code.

Other Gimmicks  

The above is an illustrative but not exhaustive list of gimmicks that should be eliminated from the tax code in the interest of fairness, simplicity as well as raising the revenue that is needed to support programs approved by Congress.  The same analysis should be applied to all other provisions in the tax code that provide for special treatment of certain items of income and deduction, so that the tax code becomes simply about raising revenue, not promoting conduct that somebody in Washington thinks is desirable.

It may well be that the government should promote activities which benefit society as a whole – green energy, home ownership, infrastructure investments in underserved areas, etc., but government support for these activities should be enacted as above-the-line grants, not tax code provisions, so that Congress can determine whether the hoped -for results are in fact being achieved in its annual budget reviews.

Other Changes

Income Tax Filing Requirements

The income tax by design is a tax on disposable income, i.e., income which is more than the amounts needed to provide for basic living expenses such as food, clothing, housing, education and health care.  That is recognized in part by the fact that a significant standard deduction is allowed against taxable income, and credits against tax are allowed for, among other things, people with children who have modest incomes.[1]  

As a result of these tax code provisions, lower-income households pay relatively little income tax.[2]  As of 2021, only 2.3% of all income taxes were paid by the bottom 50% of filers although they filed half of the total returns, nearly 77 million returns.  

This suggests that huge  compliance cost savings could be achieved with little or no revenue loss by eliminating return filing requirements for low and modest income taxpayers.  While the mechanics of this change would require careful thought, an approach that would likely work would be to allow or require withholding on common sources of income at rates based on income and family size and then require the government to treat the withheld amounts as full satisfaction of the taxpayer’s liability. The filing of returns could be allowed to deal with special cases, e.g., catastrophic medical expenses or other special circumstances, but would not be required most of the time.

Medicare Taxes

Under the current tax law, all wage earners are assessed a 2.9% tax on wages to fund Medicare, a program which provides health insurance primarily to seniors over the age of 65.  However, there are no work requirements for Medicare and therefore no obvious reasons why Medicare should  be supported by taxes on wages and not by taxes on other sources of income.

The Code currently provides that there is a 3.8% tax on “net investment income” of taxpayers with incomes of over certain thresholds, an attempt to put some of the Medicare tax burden on investment as opposed to wage income.[3]  However, this tax puts another set of complex rules in the tax code and in any case does not go far enough because not all investment income is taxed.  A fairer and simpler solution to this problem would be to eliminate the Medicare tax on wages entirely and collect the same money from the income tax by adjusting the rates.    

Estate and Gift Taxes

These taxes are grossly inefficient because they require substantial compliance efforts by taxpayers and their advisors and yet yield insignificant Federal revenue.[4]  As of 2023, total revenues from estate and gift taxes were approximately $33 billion, or less than 1% of total revenues of around $4 trillion.

They may also be burdensome for large estates with substantial illiquid assets, such as farms or closely held businesses, because a tax of nearly 40% of the value of the estate is due in cash nine months after the date of death.[1]  In view of all of this it is time to  consider whether tax laws that require so much paperwork,  cause liquidity issues for taxable estates and yield a fraction of 1% of government revenue should be either reformed or eliminated.

On one hand, some are of the view that transfer taxes on large estates are important check on wealth and income inequality – which by the way are worse in the U.S. than in any other developed country.[2] On the other hand, if weare serious about simplifying the tax code, these taxes with their enormous complexity and minimal revenue yield need to be reformed in some way.

One approach would be to replace the estate tax with an inheritance tax which would treat inheritances, either in total or above some threshold, as income.  Liquid assets such as cash and marketable securities would be taxable upon receipt; illiquid assets, such as real property or closely held businesses, would not be taxable immediately but would have income tax bases equal to the amounts paid for them by the heirs – usually zero.  Taxes would become due as the heirs sell, refinance or otherwise liquidate those assets.[3]  

This approach would  not require estates to hold any fire sales to pay taxes because at the time of settlement no taxes would be due.  Taxes would become due as the funds needed to pay them become available. This approach would also be a major step towards fairness, because it would require inheritors to pay taxes on their income at the same rates as others who get income in the form of wages or as returns on their investments.[4]              

Can’t We Just Cut Spending?

Political leaders who oppose meaningful tax reform are fond of saying that our deficit problems are really spending problems which can be solved by cutting government spending –without, of course, specifying the areas in which spending should be cut.  In fact, some right-wing politicians have sought to use tax cuts as a way to force cuts in government budgets.[1]  Unfortunately, spending cuts are unlikely to balance the U.S. budget anytime soon.

First of all, government spending in the U.S. is already lower as a percentage of GDP than in most other industrialized countries. As of 2020, Federal government spending as a percent of GDP in the U.S. was about 25.5% versus 33.5% as the OECD average – the U.S. percentage ranked32d out of 38 OECD countries, whereas in some countries (e.g., Denmark, France)government spending was over 45% of GDP. These numbers are all the more remarkable considering that the U.S. has the world’s most expensive military and the world’s most expensive and inefficient health care system.[2]

Second, all of the big-ticket items in the Federal budget including Social Security, Medicare/Medicaid and the military, are very popular, are supported by powerful lobbies, viz.,  big pharma, the health insurance industry and defense contractors a/k/a the military-industrial complex, and are unlikely to be cut by any political leader who values re-election.

The last serious attempt to cut Social Security by then-Speaker of the House Paul Ryan in2012 was so controversial that the legislation he proposed never made it out of committee. Medicare meanwhile continues to be an enormously popular program benefitting senior citizens, who can be counted on to vote on matters which affect their interests.

There area couple of areas of the Federal budget which have the potential for meaningful spending reductions, specifically amounts spent on medical care and on defense.  Since the U.S. spends around 17% of GDP on healthcare versus an average of 12% for other developed countries and has a defense budget larger than the next 9 countries combined, there is at least the potential for big savings in these areas. [3]   However, for the reasons stated above, meaningful reforms to these programs will require a lot of work and major expenditures of political capital and are not likely to happen anytime soon.  

For these reasons, more tax revenue is going to be required to balance the U.S. budget, at least in the near term.

To summarize, the tax code needs to be reformed in ways which will (1) raise enough money to support programs approved by Congress, (2) eliminate at least the worst instances of unfairness in the current system and (3) reduce  compliance costs to a reasonable level.  

The first set of changes should eliminate tax gimmicks because these are unfair, reduce revenues and increase compliance costs. The second set of changes should change income tax reportingrequirements so that most low and middle-income taxpayers are no longer required to file tax returns and the government treats the amounts withheld from their income as full payment of their income tax liability.  

Third, careful consideration should be given to elimination of the current estate and gift taxes as these generate major compliance costs and raise insignificant revenue for the government.  As noted above, a tax on inheritors would be simpler and more efficient and would likely raise significantly more revenue than the current estate and gift taxes. Such a tax would also make at least a modest dent in reducing income inequality, which as noted earlier is worse in the U.S. than in practically all other developed countries.  

Finally, current tax rates should be adjusted to whatever extent is needed so that the income tax, when added to the payroll tax and other Federal taxes, raises enough money to support the government.  Since the other changes proposed here are likely to generate substantial revenues, rate adjustments which increase rates substantially from current levels will likely not be required.

Chris Toews

February 17, 2025

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[1] The most well-known advocate of cutting taxes to force reductions in the size of government was Grover Norquist, who once said, “I don’t want to abolish government. I simply want to reduce it to the size where I can drag it into the bathroom and drown it in the bathtub.”

[2] See note 26 below.    

[3] According to Centers for Medicare& Medicaid Services, health care spending in the U.S. was $13,494 per person in 2022 or about 17.3% of gross national product.   This compares with an average of around 12%for all OECD countries.

As to military spending see https://www.statista.com/statistics/262742/countries-with-the-highest-military-spending, which reports that the U.S. spends more on the military than the next 9 countries combined.

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[1] In practice this has not been a big issue because the Code provides that tax attributable to most illiquid assets can be paid in installments over as long as 15 years at a low rate of interest.  

[2] The U.S. has the highest income inequality of any country in the G-7. See, e.g., K. Schaeffer, 6 facts about income inequality in the U.S. (Pew Research Center, Feb. 7, 2020).

[3] The proceeds of the refinancing would be added to the cost basis of the asset.  

[4] It should be noted that some assets, mostly retirement accounts, are already taxed in this way.   Inherited accounts are not subject to income tax immediately, but distributions are taxable to the inheritor when they are made.  

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[1] As of this writing, the standard deduction is  $14,600 for single filers and $29,200 for married couples.  The earned income tax credit can be as much as $7,830 as of 2024 depending on the size of the taxpayer’s family.

[2] They do, however, pay substantial amounts of their income in payroll taxes and for sales, property, fuel and other regressive consumption taxes which do not take ability to pay into account and which disproportionally affect low-income earners.

[3] The thresholds are currently$125,000 for single filers and $250,000 for married couples filing joint returns.

[4] In the author’s practice, charges of $10,000 or more to prepare an estate tax return are not uncommon.

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[1] See Keightley, Economic Analysis of the Home Mortgage Interest Deduction (Congressional Research Service, June 25, 2020)

[2] Keightley, supra, suggests that the deduction may have a larger effect on the size of homes purchased than on the decision to become a homeowner.

[3] Keightley, supra also suggests that attempting to promote homeownership via the tax code may distort the allocation of capital and labor, which could hinder the economy’s performance in the short run and long run.

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[1] Among other things, employer-provided health insurance coverage forces people to stay in jobs they hate because they cannot afford to lose coverage and ends when  the employee is forced to retire due to serious illness, i.e., it goes away when needed the most.      

[2] See, e.g., Greenspan and Vogel, Taxation and Its Effect Upon Public and Private Health Insurance and Medical Demand (Medicare and Medicaid Research review, Spring 1980).

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[1] In fact, the heirs may end up with a tax loss if they sell for the date of death value, because “value” for that purpose does not take into account commissions and other selling expenses.

[2] As of this writing, the estate tax exemption is $13.61 million per person or $27.22 million for a married couple.  Although these exemptions are scheduled to sunset at the end of 2025, the new exemptions will still be roughly half of the current ones -- $7 million or so per person or $14 million per married couple after indexing for inflation.

[3] Internal Revenue Code § 106.  While self-employed persons are allowed to deduct medical insurance premiums, they are required to report the premiums as wage income subject to income tax.

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[1] Hungerford, The Economic Effects of Capital Gains Taxation (Congressional Research Service, June18, 2010, pp. 4-5.

[2] Hungerford, supra p.6.

[3] Center for American Progress, Capital Gains Preference Should be Ended, Not Expanded (September 28, 2020)

[4] Internal Revenue Code §§ 1245,1250.

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[1] Estimates of the Joint Committee on Taxation for 2023 [JCX 59-23, December 7, 2023].

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[1] The right-leaning Tax Foundation estimates that tax compliance costs, including out-of-pocket costs and the value of time spent on tax compliance tasks, will total $546 billion this year or about 13% of revenue collected.

[2] The current national debt is financed at an average cost of about 3.3%. However, that number reflects debt obligations issued when interest rates were lower and will continue to rise, at least in the near term, even if current high interest rates decline.

[3] See, e.g., Hungerford, Taxes and the Economy: An Analysis of the Top Rates Since 1945 (Congressional Research Service, September 14, 2012, which finds that there is no statistically significant association between top tax rates and GDP growth.  Other researchers have reached the same conclusion, e.g., Gale and Samwick, Effects of Income Tax Changes on Economic Growth (Brookings Institution, September 2014), which concludes that long- persisting tax cuts financed by higher deficits are likely to reduce, not increase, national income in the long term.

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