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 tax-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 tax.
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.
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 exemption only, assuming tips as a share of total wage income remains as it was in 2018 and applying the marginal tax rate 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).
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.
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 bracket) 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.