Frustrated with Tipping? No Tax on Tips Could Make It Worse

Have you noticed more businesses asking for tips lately? You’re not alone. According to a Pew Research survey from 2023, 72 percent of Americans have seen an expansion of tipping expectations over the past five years. While some Americans are certainly frustrated about the trend, one recent policy proposal could make it worse.

Former President Donald Trump has proposed making all tip 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. -exempt. In the wake of this proposal, bills to exempt tip income have cropped up in both the House and Senate. Both the former president and the idea’s congressional advocates argue it will lower costs for working-class Americans. But it’s a poorly targeted change, with the potential for unintended consequences for both consumers and the federal budget.

The Senate bill, introduced by Sen. Ted Cruz (R-TX) and titled the “No Tax on Tips Act,” would create a 100 percent above-the-line deduction for cash tip income, with cash in this context referring to payments in physical currency, debit or credit card payment, or checks. Non-cash tips (like a ticket, a coupon, or some other item of value) would presumably remain taxable. Additionally, both cash and non-cash tips would remain taxable under 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. . Rep. Byron Donalds (R-FL) has introduced a companion bill in the House. However, a different House bill, introduced by Rep. Thomas Massie (R-KY) and Matt Gaetz (R-FL) and titled the “Tax-Free Tips Act of 2024,” would exempt tips from both income and payroll taxes.

A Poorly Targeted Proposal

At the most basic level, exempting tips from taxation would help workers who receive a large share of their income from tips. But tipped workers are a small share of the workforce: according to an analysis from Ernie Tedeschi at the Yale Budget Lab, only 2.5 percent of the workforce work in tipped occupations, and only 5 percent of workers in the bottom 25 percent of earners do. As such, the policy would leave the vast majority of low- and middle-income earners out of the loop.

Additionally, some tip income earners already do not pay personal income taxes, as some (mostly part-time) tipped workers earn less than the standard deductionThe standard deduction reduces a taxpayer’s taxable income by a set amount determined by the government. It was nearly doubled for all classes of filers by the 2017 Tax Cuts and Jobs Act (TCJA) as an incentive for taxpayers not to itemize deductions when filing their federal income taxes. , and others benefit from the earned income tax creditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. (EITC) and/or child tax credit (CTC) to the extent that they wipe out any federal income tax liability.

How Tax-Exempt Tips Would Change Behavior

But this shortcoming is not even the most significant potential problem. By making one type of income (tips) exempt from income tax, while other types of income (most importantly, wages) remain taxable, the proposal would make more employees and businesses interested in moving from full wages to a tip-based payment approach. That would mean more service industries adopting the restaurant industry approach of a list price up front and an expected voluntary tip at the end of the transaction.

This kind of behavioral response makes it difficult to estimate the cost of the no-tax-on-tips proposal. A simple analysis of tipped income suggests a lower bound cost of around $107 billion over 10 years for an income 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. only, assuming tips as a share of total wage income remains as it was in 2018 and applying the marginal tax rateThe marginal tax rate is the amount of additional tax paid for every additional dollar earned as income. The average tax rate is the total tax paid divided by total income earned. A 10 percent marginal tax rate means that 10 cents of every next dollar earned would be taken as tax. on wages faced by taxpayers making between $30,000 and $40,000 (waiters and waitresses earn a median wage of about $32,000 and a mean wage of $36,500).

Small behavioral effects, such as higher tips in existing tipped occupations, would incrementally raise that cost. More substantial behavioral responses, such as previously untipped occupations introducing tipping, could make the policy dramatically more expensive.

One could imagine a scenario in which, say, highly compensated lawyers or accountants begin to receive some of their income as voluntary tips. Lawmakers could design the exemption to prevent or minimize exploitation, such as restricting the tax exemption to taxpayers below a certain income threshold or only to tipped income received in traditionally tipped occupations. Additionally, for tip income to be tip income, the payment must be made voluntarily by the customer and cannot be previously agreed upon (among other restrictions), so arrangements to agree upon a “tip” before providing, say, legal services would be illegal, but that could prove challenging for the IRS to enforce. Additionally, lawmakers could reduce the incentive to recharacterize income by placing a cap on the amount of tip income that could be exempted.

The existing no-tax-on-tips bills do not offer much in terms of safeguards to prevent potential abuse. But even with safeguards, the policy would be poorly targeted at low- and middle-income earners, given the relatively small share of the population working in tipped occupations. Worse, the exemption itself, and any safeguards added, would add to the complexity of the tax code overall.

Is There a Better Approach?

What is a good alternative to the no-tax-on-tips idea to cut taxes for low- and middle-income workers? For tip-based workers that already pay no federal income taxes, there isn’t one, save for outright redistribution, given they have no taxes to cut. But if the goal is to deliver tax relief to lower- and middle-income taxpayers, raising the standard deduction (which effectively serves as a 0 percent federal income tax bracketA tax bracket is the range of incomes taxed at given rates, which typically differ depending on filing status. In a progressive individual or corporate income tax system, rates rise as income increases. There are seven federal individual income tax brackets; the federal corporate income tax system is flat. ) would achieve that regardless of occupation.

Consider two individuals: a cashier named Tracy and a waitress named Susan. Tracy and Susan each earn $34,000 in income. Tracy receives all of her income in wages, while Susan receives $19,000 in wage income and $15,000 in tips. Under the status quo, they each take the standard deduction and end up paying around $3,350 in taxes.

Under the no-tax-on-tips proposal, Tracy sees no tax cut. However, Susan is able to take the new above-the-line deduction for tip income, reducing her adjusted gross incomeFor individuals, gross income is the total pre-tax earnings from wages, tips, investments, interest, and other forms of income and is also referred to as “gross pay.” For businesses, gross income is total revenue minus cost of goods sold and is also known as “gross profit” or “gross margin.” by $15,000. The deduction reduces Tracy’s taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. to just $4,400, leaving her to pay only $440 in federal income taxes, resulting in a tax cut of more than $2,900.

On the other hand, increasing the standard deduction by $6,000 would provide both Tracy and Susan with a $720 tax cut. While both tax cuts in this example sum to less than Susan’s tax cut under the no-tax-on-tips scenario, it is worth keeping in mind that there are many more Tracys than Susans in the US economy.

$6,000 Increase in Standard Deduction

	Tracy (Cashier)	Susan (Waitress)
Wage Income	$ 34,000.00	$ 19,000.00
+ Tipped Income	$ -	$ 15,000.00
Adjusted Gross Income	$ 34,000.00	$ 34,000.00
- Standard Deduction	$ 20,600.00	$ 20,600.00
Taxable Income	$ 13,400.00	$ 13,400.00
Tax Liability	$ 2,628.80	$ 2,628.80
Wage Income	$ 720.00	$ 720.00

In the long term, raising wages and employment opportunities for workers across the board should be the goal. The tax policy that would best accomplish that is expensing for capital investment, which would encourage businesses to increase investment and, over time, this would boost worker productivity and wages. It is not a quick fix, but it is the right fix—and it is worth doing even if the impact takes several years to fully materialize.

“No tax on tips” might be a catchy idea on the campaign trail. But it could create plenty of headaches, from figuring out tips on previously untipped services to an unexpectedly large loss of federal revenue.

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