No Tax on Tips and Overtime Proposals Gain Steam Across States, but Remain a Bad Idea

What was once an obscure exemption passed by Alabama back in 2023 as a response to the bad labor market following the COVID-19 shutdowns has come to the forefront of policy in many states, due in no small part to President Donald Trump’s 2024 reelection campaign. Exempting all or a combination of tips, overtime, and bonuses from income taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. is popular with voters, though seemingly not a high priority for most. Regardless of popularity, though, standing for sound tax policy is still the right thing to do, especially when there are other, more economically efficient, means to provide tax relief (particularly if the goal is to offer relief to lower-income households).

Proponents of such tax exemptions argue that they offer a lifeline to workers in low-wage and labor-intensive sectors. For tipped workers—such as waitstaff, bartenders, and delivery drivers—tips often constitute a significant portion of income, supplementing base wages that may fall below the standard minimum wage in some states. Similarly, overtime exemptions would benefit hourly workers—think nurses, factory workers, or firefighters—who rely on extra hours to make ends meet. In Alabama, the only state with an active overtime tax exemptionA tax exemption excludes certain income, revenue, or even taxpayers from tax altogether. For example, nonprofits that fulfill certain requirements are granted tax-exempt status by the Internal Revenue Service (IRS), preventing them from having to pay income tax. as of 2025, data have suggested a boost in labor supply and personal earnings. Bonuses, often tied to performance or seasonal work, could also become more rewarding if untaxed, incentivizing productivity.

Beyond individual benefits, supporters contend that these exemptions could stimulate local economies. Workers with higher disposable income are more likely to spend, boosting demand for goods and services. In states like Kentucky or North Carolina, where bills propose exemptions starting in 2026 or earlier, lawmakers envision a virtuous cycle: untaxed earnings fuel consumption, which in turn supports businesses and job creation. Politically, the idea resonates with a broad swath of voters: 73 percent of Americans across party lines supported no taxes on tips in a 2023 poll.

The trend of exempting tips, overtime, and bonuses from taxation has roots in both federal rhetoric and state-level innovation. At the federal level, proposals to eliminate taxes on tips and overtime gained traction during the 2024 presidential campaign, with Donald Trump and Kamala Harris advocating for such measures as a way to support service workers and incentivize extra hours. Even before this, states had taken up the mantle, with Alabama leading the charge as the first to enact a no-tax-on-overtime policy from 2024, reporting a subsequent 5 percent spike in volunteered overtime. Other states, such as North Carolina with its “No Tax on Tips, Overtime, Bonus Pay” bill (House Bill 11), aim to extend exemptions to the first $2,500 of annual bonuses alongside tips and overtime. Kentucky, Maryland, Nebraska, and New Jersey have introduced similar legislation, often tying these exemptions to broader tax relief packages or minimum wage adjustments. This wave of activity reflects a broader sentiment: workers deserve to keep more of their earnings, especially in industries where tips or overtime form a significant portion of income.

Why It’s Bad Policy

Despite its populist allure, exempting tips, overtime, and bonuses from taxation is a flawed idea that undermines economic fairness, distorts labor markets, and jeopardizes tax revenues. First, it introduces severe horizontal inequity in the tax code. Two workers earning the same annual income could face vastly different tax burdens simply because of the nature of their livelihoods.

Consider two taxpayers earning $30,000 annually in a state with a flat 5 percent income tax: Tracy, a secretary, and Bob, a waiter. Tracy earns all income as wages, while Bob earns $20,000 in wages and $10,000 in tips. Under current law, both claim the $14,600 standard deduction and owe $770 in state income tax. If the state passes a “no tax on tips” law, Tracy’s tax liability remains $770, but Bob’s tips become exempt, reducing his taxable income to $5,400 and his tax to $270—a 65 percent cut.

Tax Scenarios

A hotel clerk earning $39,500 partly through overtime will pay less tax than a car rental clerk earning the same amount through regular hours, despite identical financial circumstances. A worker given a year-end bonus will be subject to lower taxes than another worker who makes an equal amount of money via only salary.

These sample disparities highlight the biases inherent to such laws: they arbitrarily reward some workers over others facing the same financial circumstances. This arbitrary favoritism lacks a coherent policy rationale and disadvantages workers unable to access tipped or overtime-heavy roles, such as those with caregiving responsibilities or fixed schedules.

Second, these exemptions create perverse incentives for employers, workers, and policymakers alike. By making tips and overtime tax-free, employers may feel less pressure to raise base wages, effectively shifting the burden of compensation onto tax policy rather than payroll. Tipping fatigue, already chronic in the country, is likely to be exacerbated as more industries respond to the incentives created by such misguided laws. Employers might also restructure pay to favor bonuses or overtime over hiring additional staff, reducing job opportunities and encouraging overwork. Worse, high earners could exploit these exemptions by reclassifying income as tips or bonuses, a loophole already flagged by tax experts as a risk for professionals, like lawyers or consultants. This could also stall efforts to implement genuine tax reforms, with legislatures choosing to rest on the laurels of these popular (but ineffective) pieces of legislation as easy political wins while subjecting the economy to the costs of these inefficiencies.

Third, the fiscal costs of such measures are significant, and they are poorly targeted. Estimates suggest that exempting overtime alone could cost the federal government between $680 billion and $1.5 trillion over a decade, depending on whether the exemption also applies to the payroll taxA payroll tax is a tax paid on the wages and salaries of employees to finance social insurance programs like Social Security, Medicare, and unemployment insurance. Payroll taxes are social insurance taxes that comprise 24.8 percent of combined federal, state, and local government revenue, the second largest source of that combined tax revenue. , and states are likely to see similar proportional costs. Alabama’s experience with its 2023 overtime tax exemption (Act 2023-421) offers a cautionary tale. Initially projected to cost $34 million annually, the exemption reduced state revenue by $230 million in its first year, with a total cost of $345 million expected by its July 2025 sunset. States like Montana, which recently reversed a tip exemption, illustrate the budgetary trade-offs: lost revenue means less funding for schools, roads, or anti-poverty programs, often necessitating cuts or tax hikes elsewhere. Moreover, only a small fraction of workers—about 2.5 percent of the national workforce are tipped, and roughly 55 percent qualify for overtime, but do not necessarily receive it—stand to benefit, leaving a sizeable proportion of low- and middle-income earners unaffected. Indeed, among the bottom half of hourly wage earners, less than 4 percent are in tipped occupations. Among the bottom quarter, the share is 5 percent.

Finally, these policies complicate tax administration and invite avoidance. Distinguishing between regular wages, tips, overtime, and bonuses adds bureaucratic overhead for employers and the revenue departments of the states, increasing errors and evasion risks. The lack of uniformity across states further muddies the waters, creating confusion for taxpayers and administrators alike.

A Better Path Forward

Rather than pursuing gimmicky tax exemptions, policymakers should focus on structural reforms that lift all workers without distorting markets or draining public coffers. Where standard deductions are well below the federal deduction, increasing them would provide broad-based relief, taking some taxpayers off the tax rolls altogether. Decreasing marginal tax rates would increase the returns to labor, encouraging an increase in labor supply and consequently economic output and tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. .

Updating overtime laws to raise eligibility thresholds—currently just $35,568 annually—would ensure more workers receive time-and-a-half pay without relying on tax breaks. This tackles overwork at its source, compelling more employers to fairly compensate extra hours rather than offloading the cost onto taxpayers.

Conclusion

The trend of tax exemptions on tips, overtime, and bonuses may sound like a win for workers, but it is a shortsighted fix with long-term drawbacks. It creates winners and losers among workers with equal incomes, distorts labor markets, and undermines public finances—all while failing to help the American workers struggling the most. A better path lies in economic growth, higher standard deductions, and strengthening overtime protections. These steps address some of the economic strain, at the lowest efficiency loss, ensuring fairness and sustainability over populist promises that do not hold up under scrutiny. As states and the federal government weigh these policies in 2025, they should prioritize solutions that lift everyone, not just a select few.