Tip Off: The Problem with Exempting Tips from Taxes

The Issue:

There are seemingly few areas of policy agreement between the two major-party presidential candidates. Yet one area in which they do coincide has drawn widespread criticism from economists. Both Vice President Kamala Harris and former President Donald Trump have announced proposals to exempt tips from federal taxes as a way to improve the economic standing of low-wage workers, much to the chagrin of economists across the ideological spectrum. The idea has broad appeal, with about three quarters of Americans polled saying they are in favor of eliminating taxes on tips. Why are so many economists opposed?

Exempting tips from taxes does nothing to help most low-income workers, and it may do little for many tipped workers—or even actively harm them.

The Facts:

• Both candidates’ proposals to exempt tips from taxes are preliminary but present potential differences. Both presidential candidates first mentioned their proposals in the swing state of Nevada at Las Vegas campaign rallies, where a large share of the labor force is employed by the leisure and hospitality industry. Vice President Harris would exempt tips from income tax but not payroll taxes—the contributions that people make to Social Security and Medicare. Her proposal would allow workers in the service and hospitality industries with income below $75,000 to claim exemptions up to a (currently unspecified) capped amount. Though the Trump campaign has offered scant details, it appears that his proposal would not limit the tax break by sector or income level. This would match two recently introduced bills, one by Senator Ted Cruz (R-TX) and Representative Byron Donalds (R-FL) and the other by Representatives Thomas Massie (R-KY) and Matt Gaetz (R-FL). But it is unclear whether former President Trump would exempt tips from payroll taxes. The Cruz-Donalds proposal would apply only to the income tax, while Massie-Gaetz would apply to payroll taxes as well. 
• Only a small share of workers in the lower end of the income distribution are employed in tipped occupations. Workers who customarily receive more than $30 per month in tips are considered tipped workers by the U.S. Labor Department. There were an estimated 4 million workers in tipped occupations in 2023 making up about 2.5% of all employment, according to a report by the Budget Lab at Yale University. Among workers in the bottom earnings quartile, only 5% earn tips and could possibly benefit from the proposal.
• The tax exemption is not likely to benefit the lowest-earning tipped workers. Among tipped workers, 37% earn so little that they pay no federal income tax and so would not benefit from the tax cut. This is not the case for all tipped workers. The top earning 10% of waiters and waitresses, such as wait staff in high-end restaurants, make over $60,000 a year and could benefit from the tax exemption. On top of this, it is worth noting that tipped workers with high enough earnings to pay federal income tax have a high rate of tax evasion and thus may be paying less in taxes than equivalent workers in non-tipped occupations anyway. Employers might also benefit from the change in tax policy as they might simply cut workers’ base pay, pocketing the would-be gains for themselves. Business owners could attempt to reclassify employees as tipped workers under the guise of a tax break, only to then also drop their pay to the lower tipped minimum wage (currently $2.13 per hour federally, compared to $7.25 per hour for non-tipped workers). 
• Exempting tips from taxation risks depriving workers of several federal benefits. For instance, if the Trump proposal in fact shields tips from payroll taxes, then workers—perhaps unknowingly—would receive reduced retirement benefits, which are based on total career contributions to Social Security and Medicare. Similarly, the Earned Income Tax Credit (EITC) phases in for low income workers, meaning that, if a family earning tipped wages has their taxable income drop below a certain threshold, they will lose benefits, potentially even more than the corresponding tax cut. The Center for American Progress, in reviewing the Cruz-Donalds proposal, finds that savings might also be fully offset by lower Child Tax Credit (CTC) benefits for many families. 
• Treating tipped workers differently from workers of similar incomes who are employed in non-tipped occupations creates inequities. A carveout for tips violates the basic principle of equity, a cornerstone of sound tax policy. Exempting income earned as tips for a waitress, but not wages earned by a teacher, ensures that two taxpayers with the same level of income would pay markedly different amounts of tax. And the proposals could make state tax collections more complex. 
• Giving one type of income preferential treatment automatically creates an incentive for taxpayers to find ways to label their income that way. Under the Trump proposal, for example, what is to stop lawyers from slashing their rates and allowing clients to pay them a large, tax-free tip for their services? Also, enacting the proposal would open the door for others to seek relief for their particular form of income, such as the bonuses or commissions that hedge fund managers and investment bankers earn. Although the Harris campaign has attempted to limit these outcomes through its proposed guardrails, this would only serve to complicate a tax system already mired in a dizzying array of exemptions, all while the IRS has limited resources to shut down loopholes for wealthy tax cheats as it is. 
• Reductions in tax receipts from enacting such policies would aggravate the U.S. debt problem long-term. According to recent analyses from Committee for a Responsible Federal Budget (CRFB), the Trump plan would cost between $150-200 billion over the next decade, while Harris’s plan would cost a little less than half of that, due to her proposed targeting. However, when combined with a concurrent proposal to raise the minimum wage, CRFB estimates that Harris’s plan would still cost $100-200 billion. Furthermore, these estimates assume that there is no behavioral response to the new policy. If workers instead shift a higher portion of their income into tipped wages, then the costs of these proposals could quickly balloon to as much as $325 billion for Harris and $500 billion for Trump.