Special Income Tax Treatment of Tip and Overtime Income

I. Legislated Changes on Tip and Overtime Income

Tip income will be essentially exempt from the income tax, for some taxpayers with tips in certain industries for the 2025 to 2028 tax years. Reported tip income is to be included in gross income, but it is deductible, up to $25,000 per tax return, from gross income. (Married couples must file jointly to qualify for the tip deduction). Qualified tips, defined as voluntary payments by customers, are from occupations that the IRS lists as customarily receiving tips.¹ Both employees and self-employed taxpayers are eligible to deduct qualified tips from their income. For the self-employed, deductible tips cannot exceed the gross income (including the tips) less the deductions from the associated trade or business (i.e., tips can only be excluded from business income not income from other sources). Some key details:

• The deduction phases out for modified adjusted gross incomes (MAGI) above $150,000 for single filers and $300,000 for married filers. The benefit of the deduction completely phases out at MAGI of $400,000 for single taxpayers and $550,000 for married taxpayers. 
• Tip income is still subject to FICA contributions and the self-employment tax that covers FICA taxes for the self-employed.  
• Employers must furnish information returns documenting the tips and the occupation of the recipient. For unreported tip income, taxpayers must include documentation of the tip income and include it gross income.

The premium portion of overtime pay will be deductible from gross income. Overtime income is the “half” in “time-and-a-half” overtime pay that is required by the Federal Fair Labor Standards Act. Employers are required to report overtime income to the IRS and to the employees.Since it is deductible it is exempt from income taxation.  But the deductibility is subject to various limitations. These include:

• The maximum deduction is $12,500 for single taxpayers and $25,000 for married taxpayers. Married taxpayers must file jointly to take the deduction. 
• The deduction phases out for MAGI above $150,000 for single taxpayers and $300,000 for married filers. The deduction completely phases out at MAGI of $275,000 for single taxpayers and $550,000 for married taxpayers.

II. The Complexity and Administrability of These New Tax Provisions

Tax rules should be kept simple to reduce compliance costs for taxpayers and administrative costs for the tax authorities. Simple rules also increase perceptions of procedural fairness in the tax system, which may lead to improved tax compliance and less tax evasion. However, the new tax rules that exempt some tip and overtime income from the tax base make the tax system more complex. There are a number of problems that arise from these new rules.

The new rules do not reduce the amount of record keeping or information reporting. The tip and overtime income must still be tracked and is included in the FICA tax base. Rather, the amount of information reporting increases as employers need to document whether the occupation is among the qualified jobs for the exclusion of tip income and other aspects of tip income. 

Creating a list of occupations that the IRS lists as customarily receiving tips may be seen as arbitrary distinctions in the tax code. The New York Times presented a titillating example of the complications involved in the new tax law; the Treasury Department excluded jobs considered “pornographic activity” (even if legal) from qualifying for the deduction, but this requires the IRS to adjudicate what is pornography.² While this particular example seems arcane, it highlights the administrative complexity of the law.

There is not a simple, straightforward definition of “tips.” The legislation specifies that to qualify as a tip a payment must be “paid voluntarily without any consequence in the event of nonpayment, is not the subject of negotiation, and is determined by the payor.” Even this simple definition of a tip raises compliance issues. For example, a mandatory service charge that is added to a bill does not meet this definition. 

There are also problems with the definition of overtime pay. The no tax on overtime provision is more straightforward than defining qualified tip income because it relies on the overtime requirements of the Fair Labor Standards Act (FLSA), but this reliance on the FLSA means that some overtime pay does not qualify for the special tax treatment. Specifically, voluntary agreements between employers and employees (including their unions) that may exceed the FLSA requirements are not covered by the law. 

These new laws incentivize changing work agreements to take advantage of these tax breaks. Special tax provisions often create tax planning incentives to reduce tax burdens. For these provisions, one might expect work arrangements to shift towards more reliance on tip and overtime pay as part of overall compensation.

The new rules have complex interactions with state fiscal systems. Forty-one states have personal income taxes. A natural question is how the Federal change affects state law. For 18 states, the income tax base automatically adjusts to follow Federal tax rules (known as rolling conformity).³ These states would need legislation to decouple from the Federal changes. Another 18 states use static conformity, such that their definition of taxable income is tied to Federal rules at some past date (e.g., January 1, 2022). These states could change their conformity date or pass legislation to selectively conform with Federal changes. Five states do not conform specifically to the Federal tax code, but they often adopt rules that mirror Federal rules. One implication of variation in conformity between state and Federal tax rules is that people in different states will experience different state income tax treatment on tip income, which may make filing taxes slightly more complicated because state rules differ from Federal rules in some states. A second implication is that by following the Federal tax treatment of tips and overtime, the states will experience a decline in state tax revenue. Unlike the Federal government, almost all states have some sort of balanced budget rule that prevents deficit spending. The tax cut on tips and overtime will mean that states that adopt this rule (either automatically through rolling conformity or selectively through legislation) will need to raise revenue through other means or cut spending. The budgetary implications will be especially important for states with rolling conformity because without new legislation, their balanced budget rule may bind.

III. Equity Issues Raised by Exempting Some Tip and Overtime Income

Tax laws should attempt to preserve both horizontal and vertical equity. Horizontal equity means similar tax burdens for people with similar incomes. Vertical equity refers to how the tax burden is distributed over the income distribution. The new tax and overtime rules violate both of these goals by creating different tax treatment for people in similar circumstances and by affecting how the tax burden is distributed across taxpayers with differing abilities to pay.

These new rules violate horizontal equity. Consider two people who earn a similar total income of $40,000, but one person earns $30,000 in wages and $10,000 in tips while the other person only has wage income. The no tax on tips rule creates a tax cut for the first person but does not help the second person. Alternatively, compare someone who earns $10,000 in overtime pay with someone who has the same income from their first job but earns an additional $10,000 working a second job. Each of these people may have worked more than 40 hours per week, but only the person with the formal, FLSA-required overtime payment gets a tax break. These examples illustrate why the disparate treatment of tips and overtime relative to other labor income creates horizontal inequities in the tax system.

These new rules also violate vertical equity. The provisions exempting some tip and overtime pay from the income tax were the first two provisions in the chapter of the bill that provided middle class tax relief. Provisions, such as limiting the total amount of tip and overtime income that can be exempted from income tax, limitations on tip income for professional services, and the phaseout of the tax breaks at higher income levels are features of the legislation that reduce potential benefits for taxpayers with high income. Despite these provisions aimed at targeting tax relief, relatively well-off households are likely to benefit from the provisions. The phaseout rules are structured such that only a modest fraction of households is excluded from benefiting. For example, in 2022 (the most recent year with publicly released data), the IRS Statistics of Income data show that only 4 percent of married taxpayers have adjusted gross income of over $500,000 (roughly where the phaseout range ends) and only 2 percent of single taxpayers have adjusted gross income of over $200,000. The population included extends well beyond the middle class.⁴

A more detailed analysis of the distribution of who benefits from the exemption of tip income suggests the benefits do not go to lower-income households. The Tax Policy Center (TPC) provided a preliminary estimate of the distributional impact of both the tip and overtime provisions.⁵ For tip income, the TPC estimates that only 3 percent of taxpayers will benefit from the provision; overall, the average reduction in tax liability for those benefiting from the provision is $1,370. From lowest to highest quintile of expanded cash income (a common metric of household well-being), the percent of benefits accruing to each quintile are 2.3%, 14.8%, 24.7%, 37.7% and 20.5%, respectively.⁶ Thus, very little of the benefit flows to the lowest income households with a disproportionate share of the benefits accruing to the third- and fourth-income quintiles. Several factors may explain the pattern of estimated benefits. The relatively low benefits for the lowest income quintile may reflect that many of these households do not have a positive tax liability that can be offset with the deduction. Berlin and Gale report that 37 percent of tipped workers do not pay Federal income taxes because they earn too little income.⁷ The benefit of the provisions increases with the taxpayer’s marginal tax rate, which increases with income. Underreporting of tip income may also be a factor in the relatively modest overall benefits from the deduction.⁸ To the extent that taxpayers do not report tip income, the exemption will not affect their tax liability, but it would provide a legal channel to avoid taxes as an alternative to tax evasion.

The benefits of deductibility of overtime income mostly accrue to relatively well-off households. For the overtime pay provision, TPC estimates that 9 percent of tax units benefit from the provision with an average benefit of $1,440 for households that can claim this deduction. From lowest to highest income quintiles, the percent of benefits accruing to each quintile are 0.3%, 3.5%, 16.6%, 32.1%, and 47.5%, respectively. TPC estimates that the top income decile will receive 19.6 percent of the benefits of the provision. These estimates suggest that households with above the median income tend to receive the bulk of overtime income with relatively high-income households receiving a substantial fraction of the benefits of deduction. Unlike tip income, noncompliance issues are likely to be minor for overtime income since information reporting by employers is likely to capture all of this regulated form of income. 

These policies do little to achieve tax relief for the middle class. Overall, the modest number of households who benefit from these provisions raise serious concerns about violating horizontal equity norms. As for their effect on vertical equity, the average benefits within income groups suggest that the provisions are not well-targeted to improving the position of relatively low- or middle-income households. To avoid the horizontal equity concerns and more strategically target income groups, adjusting marginal rates and the breakpoints for tax brackets would be a more equitable and easier to administer policy.

IV. Economic Efficiency of Special Treatment of Tip and Overtime Income

Tax policy should aim towards reducing the inefficiencies that are associated with the need to raise revenue. Taxes distort incentives and, in so doing, reduce economic efficiency. In general, reducing inefficiencies is best achieved through a broader tax base that then allows for lower tax rates to generate the same revenue. One of the advantages of a “broad base with lower tax rates” is that lower tax rates translate to less distortion in response to the tax system. In general, excluding some types of income from taxation narrows the income tax base. However, there are tax exemptions for some types of income to increase economic efficiency by encouraging socially desirable behavior. For example, the exemption of interest on state and local debt acts as a subsidy for lending to state and local governments. This exemption enables state and local governments to provide public goods like schools and roads at a cheaper cost due to the lower interest rate afforded by this tax provision than would otherwise be the case. It is not clear that preferential tax treatment of tip or overtime income has such a justification.

It is not clear that preferential tax treatment of tip or overtime income can be justified on economic efficiency grounds. Indeed, this preferential tax treatment might have a negative effect on economic efficiency as it encourages some forms of compensation over others. For example, the preferential tax treatment of tips discourages employers from opting for a no-tip business model that pays higher wages to service workers. Such models tend to offer more stable labor income and possibly more equity between workers within a firm (e.g., front of house and back of house staff). Given the new tax provisions, such business models lead to higher tax burdens for employees (conditional on the same amount of income) than the older business model of tips paid directly from customers. Distorting business choices is a form of economic inefficiency.

V. Conclusion

The limited exclusion of tip and overtime income does not seem to improve the tax system along any of the standard dimensions used to evaluate tax policy. It adds complexity to the tax system. The promise of tax relief for the middle class could be achieved in more targeted ways at the same revenue cost. Alternatives, such as adjusting tax rates and brackets, would improve progressivity without creating horizontal inequity in the tax system. These provisions do not seem to improve the economic efficiency of the tax system. Future Congresses will need to consider whether to allow these temporary tax provisions to sunset, be extended, or made permanent features of the U.S. tax code. Furthermore, state legislators will face decisions about how to adjust their tax systems in light of the changing Federal tax rules. Those decisions should be based on the criteria discussed in this Explainer, including vertical and horizontal equity, efficiency, administrability, and complexity.