The Senate unanimously voted to eliminate taxes on tips. The bill would establish a new tax deduction of up to $25,000 for tips, among other things. A similar provision is contained in legislation passed by the House of Representatives, the so-called “Big Beautiful Bill,” which passed the House yesterday in a 215-to-214 vote.
Exempting tips from taxes is a bad idea. It will reduce tax revenue by at least $150 billion over the next decade. But that’s an under-estimate, because once tips are exempt, people in the service industry will push to have more of their income come in tips, and less in non-tip income. So the cost will be bigger than that.
But there is no reason to give special tax breaks to people with tip income. That is as unfair as exempting people who work on only Wednesdays or weekends from taxes, while forcing people to pay taxes on income they make during the week.
Exempting tip income will bias the tax code in favor of the service sector and against manufacturing, which is at odds with the goal of expanding American manufacturing.
As Jared Walczak of the Tax Foundation, who supports cutting wasteful spending, explains:
“No Tax on Tips” may sound good, but it’s poor policy.
Most low-income workers don’t receive tips, and not all tipped workers are low income. Among workers in the bottom half of hourly wages, only 4% are in tipped occupations. Why should certain categories of low-income workers receive a tax preference not available to others at similar income levels?
(In fact, many lower-income tipped workers are already exempt from federal income tax. Thirty-seven percent of tipped workers have no federal income tax liability, so the exemption would be targeted at those who already have relatively higher incomes. If your mental image is of a diner employee who makes relatively little, that may be the wrong image of the beneficiaries of this policy.)
Exempting tips, moreover, creates an incentive to convert more compensation to tips to avoid income tax. It’s not at all clear that a further expansion of tipping culture is desirable, especially if it’s in realms where it would only happen because of the tax preference.
And even assuming no increase in tipping, exempting tips will cost an estimated $118 billion over 10 years at the federal level, and meaningful amounts in any states that follow suit, while creating largely unhelpful incentives rather than prioritizing economic growth and/or delivering targeted relief. If you want to provide tax relief, is this really the best way to do it?
Does it make sense to exempt tips from income taxes? No, explains Catherine Rampbell in the Washington Post:
This is a bad idea — whether you care about equity, or the federal budget deficit, or the integrity of markets and tax administration. Tipped earnings are already relatively likely to evade taxation since they’re often transacted in cash and less traceable by Uncle Sam. Making all of these earnings legally tax-free raises even more serious questions of fairness.
Why should a waiter or blackjack dealer who gets most of their income from tips be exempted from taxes, when an employee at a nearby Walmart or a bus driver earning the same income — or perhaps much less — must pay taxes on all their hard-earned wages?
The proposal would also cost quite a bit of money. Exempting all tip income from federal income and payroll taxes…would lower federal revenue by $150 billion to $250 billion over the course of a decade, the Committee for a Responsible Federal Budget estimates….The payroll tax exemption would starve the Social Security and Medicare trust funds of needed revenue in particular, potentially hastening benefit cuts.
But even those huge sums likely understate the cost, since those estimates assume the tax policy doesn’t change anyone’s behavior. Which is a fairly rosy assumption. This new loophole would open up tons of ways to game the tax system by reclassifying more earnings as supposed “tips.” However many workers receive gratuities now — Yale’s Budget Lab estimates about 4 million people are in tipped occupations — we should expect that number to balloon….Plus, consumers are already aggravated by the proliferation of tip requests, as Tax Policy Center researcher Steven M. Rosenthal points out. Do we really want to encourage even more tin-can shaking, by cable companies, dental practices and clothing retailers, too?
By increasing the budget deficit, exempting tip income could also fuel inflation. Massive debt-financed government spending increased the inflation rate under President Biden. Those deficit-increasing policies caused inflation, according to even Democratic economists like Harvard’s Larry Summers — who was Treasury Secretary under President Clinton — and Obama economic advisor Steven Rattner.
The federal budget deficit doubled to roughly $2 trillion from 2022 to 2023, noted the Tax Foundation. And it will be around $2 trillion this year, even before accounting for any tax cuts that Republicans may pass this year. That doubling is “basically unprecedented in U.S. history during relative peace and prosperity,” noted economist Brian Riedl in September 2023.
