No Tax on Tips: Pragmatic Tax Proposal or Populist Tax Policy Nightmare?

By: Megan E. Wilson, Esq., LL.M. and Matthew E. Foreman, Esq., LL.M.

Recently, both major-party presidential candidates have come out in favor of a “no tax on tips” proposal, though neither candidate has indicated how to implement one. There have been proposals from other legislators, though none of them seem to be appropriately studied or planned, and neither candidate seems to be on the way to endorsing any specific method.

Possible Mechanisms to Remove Tips From the Tax Base

Tips are taxable because they are income, and all income is generally taxable, regardless of source, unless it is otherwise excluded, exempt, or deductible.[1] There are three mechanisms for not imposing tax on tips:

Exclusion. An item of income that is excluded from income is never included in the tax base. The most common example is a gift.

Exemption. If something is exempt from income tax, it is initially included in the tax base but then removed. This income would appear on your tax return but is not subject to tax. For example, interest from municipal bonds is exempted from tax.

Deduction. A deduction is an amount subtracted from income when calculating taxable income. Deductions are similar to exemptions because the income is includible in the tax base, but the taxpayer receives a deduction equal to the amount of the income; the difference with a deduction is that the income remains part of adjusted gross income (AGI), which is relevant when determining other tax items. One well-known example is the charitable deduction that taxpayers can receive for making a donation to a charitable nonprofit under I.R.C. § 501(c)(3).

The Bills

Senator Ted Cruz (R-TX) and Representative Byron Donalds (R-FL) introduced companion bills that would allow for a deduction equal to the amount of cash tips received.[2] The Cruz-Donalds bill is three pages long and has both posed significant issues and elicited criticism from experts.[3] The issues that would stem from the brevity of this bill would require the Treasury Department and the Internal Revenue Service to promulgate regulations and other sub-regulatory guidance to define everything from what constitutes a deductible tip to who can deduct which tips.

Representatives Matt Gaetz (R-FL) and Thomas Massie (R-KY) have also introduced a bill that would eliminate both income and payroll taxes on tips.[4] The Gaetz-Massie bill would treat tips as a gift and exclude tips from both income and payroll taxes.  If tips are considered gifts under I.R.C. § 102, they are not includible in gross income and therefore not eligible for the earned income credit or child tax credit.[5] Further, the tipper would likely need to file a gift tax return.[6]  Similar to the Cruz-Donalds bill, the Gaetz-Massie bill will likely require significant amendments before it is evaluated in earnest by Congress at large.

Other Issues

Horizontal Equity

Horizontal equity is an economic concept where individuals who are in similar economic positions (i.e., similar income and assets) should be taxed at the same effective rate on the same amount of income. Accordingly, permitting a tax benefit to people in the service industry but not to people in retail who are earning the same amount of adjusted gross income would violate horizontal equity. For example, imagine two people working 40 hours a week earning $20/hour, for a total of $41,600 a year. Individual A works for a convenience store, earning $41,600 in wages and no tips. Individual B works at a restaurant, earning most of her income from tips, perhaps $11,600 in wages and $30,000 in tips. Allowing Individual B to only pay tax on roughly 28% of her income while Individual A pays tax on 100% of her income would be bad tax policy when viewed through a horizontal equity lens.

Tipping Culture

Taxpayers generally change their behavior when the tax law incentivizes them to do so. For employers, changing the taxation of tips would incentivize them to decrease labor costs by pushing a greater portion of employee compensation toward tips, which come out of the pocket of customers instead of the employer. What might follow is that employers reduce base compensation for their employees but do not pass those savings along to consumers, meaning prices stay the same; depending on whether tips increase or decrease, the government could end up with less overall tax revenue.  And from a moral and political perspective, some people have expressed frustration with so-called “tipping culture,” and these bills would exacerbate the problems those observers complain about on a society-wide scale.[7]

The Child Tax Credit and Earned Income Tax Credit

A core tenet of any income-based progressive tax system, which the United States has implemented since adopting the Sixteenth Amendment to the Constitution, is that those who make more money should pay more tax.[8] At lower levels of income, however, there is not a direct correlation between income and tax paid because of refundable credits such as the Earned Income Tax Credit (EITC) and the Child Tax Credit (CTC).[9] The EITC and CTC both require the taxpayer to have earned income[10] to receive each credit.  For example, each credit increases as earned income increases, and then the individual becomes ineligible as earned income crosses the various phase-out thresholds.[11] If income from tips were eligible to be excluded, exempted, or deducted, tip earners could be partially or completely ineligible for the EITC or the CTC, leading to a higher effective tax rate for those taxpayers.[12]

For example, the average restaurant server reportedly makes approximately $33,000 per year, which is roughly $16/hour.[13] This is well within the limits for the EITC, which has a phaseout at $63,398 for tax year 2023. Without tips, waitstaff are earning a federal minimum wage of $2.13/hour – or approximately $4,430 per year for a full-time employee. If tips are not included in the base for calculating the EITC, that would greatly reduce the amount of credit that taxpayers will receive, thereby likely increasing their overall tax burden.

Payroll Taxes

Similar to the EITC and the CTC, if taxpayers do not make payments of payroll taxes,[14] they will be eligible for less in government benefits, which could lead to significant problems if an individual becomes unable to work or is considering retirement. It is unclear whether either presidential candidate is actually proposing removing tips from the payroll tax base, but both the Cruz-Donalds and Gaetz-Massie bills would likely do that. When considering whether to adopt this policy, Congress should look closely at its impact on eligibility for participation in the social safety net.

Taxpayers Playing Games

The more Congress creates special treatment for certain classes of income, the more likely people are to change behavior for tax reasons. Though many may be tongue-in-cheek, in the immediate days following the first widespread discussions of eliminating taxes on tips, many people were proposing that they would find ways to reclassify their income as a tip. For example, a realtor may offer to eliminate their fee if the purchaser tips them a sufficient amount.[15] Whether these proposals would actually work and be allowed by an auditor would be a different story, but it would not stop people from trying and causing both a massive administrative headache and inevitable net loss to the public fisc.

Will it be a worse outcome for tipped workers?

Many tipped workers do not report all their tips to decrease their income tax burden,[16] but when it comes time to qualify for housing or car loans, that also means they cannot show sufficient income. Eliminating taxes on tips might mean workers claim the income instead of hiding it, but there might not be substantially higher compliance if payroll taxes still apply to tips. On the other hand, if both income and payroll taxes do not apply to tips, actually tracking tips becomes less legally sensitive, and taxpayers could take a much more relaxed attitude toward accounting for tips.[17]

Conclusion

We believe it is unlikely that a law giving a tax advantage to tips would have the desired political outcome. Not only do many people already not include tips in their taxable income, but it will also almost certainly decrease the efficacy of the CTC and the EITC. The policy could also negatively impact taxpayers’ eligibility for social security benefits. The potential revenue upside to these proposals is small, the policy would benefit a relatively small group of people, and the administrative and regulatory burden on enforcement arms would be significant.[18] Finally, it is likely to increase costs for consumers due to lack of incentive to lower prices, increased compliance costs, and the governmental need to increase tax revenue from other sources. Overall, we think the proposal is poor policy and could end up benefiting none of the affected parties, both governmental and private.

[1] I.R.C. § 61; Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (1955); Moore v. United States, 144 S. Ct. 1680 (2024).

[2]No Tax on Tips Act as introduced by Ted Cruz, https://www.cruz.senate.gov/imo/media/doc/MCG24304.pdf;  No Tax on Tips Act as introduced by Byron Donalds, https://donalds.house.gov/uploadedfiles/notaxontipsactbilltext.pdf.

[3]Brendan Duke, Sen. Ted Cruz’s No Tax on Tips Act Does Little for Low- and Moderate-Wage Workers But Opens Door to Tax Abuse by Wealthy, Ctr. for Am. Progress (July 17, 2024), https://www.americanprogress.org/article/sen-ted-cruzs-no-tax-on-tips-act-does-little-for-low-and-moderate-wage-workers-but-opens-door-to-tax-abuse-by-wealthy/.

[4]Tax Free Tips Act of 2024 as introduced by Matt Gaetz and Thomas Massie, https://gaetz.house.gov/sites/evo-subsites/gaetz.house.gov/files/evo-media-document/FILE_2376.pdf.

[5] I.R.C §§ 102, 32(c)(2)(A)(i), and 24. 

[6] If the person making the gift has a single gift exceeding the current exclusion amount, which is $18,000 for 2024, then every single gift, which would include tips, must be disclosed on I.R.S. Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, which would lead to paperwork and recordkeeping nightmares, though it would be a boon for tax preparers.

[7] Alex Muresianu, Frustrated with Tipping? No Tax on Tips Could Make It Worse, Tax Foundation (July 23, 2024), https://taxfoundation.org/blog/tipping-trump-tax-on-tips/.

[8] This is generally consistent with the definition of Haig-Simons definition of income and other systems that evaluate income-based taxation systems.

[9] In fact, some commentators note that the result of the EITC and the CTC is that many low-income individuals actually receive subsidies from the government rather than actually paying tax.

[10] Earned income includes wages, salaries, tips, and other employee compensation, but only if these amounts are includible in gross income.  I.R.C. § 32(c)(2)(A)(i).

[11] See Child Tax Credit (CTC), Tax Foundation, https://taxfoundation.org/taxedu/glossary/child-tax-credit/ (last visited Oct. 10, 2024) and Earned Income Tax Credit (EITC), Tax Foundation,  https://taxfoundation.org/taxedu/glossary/earned-income-tax-credit-eitc/ (last visited Oct. 10, 2024) for graphs illustrating income levels and the corresponding credits.

[12] Ernie Tedeschi, The “No Tax on Tips Act”: Background on Tipped Workers, The Budget Lab at Yale (June 24, 2024), https://budgetlab.yale.edu/news/240624/no-tax-tips-act-background-tipped-workers. This principle would also violate horizontal equity.

[13] Waiter and Waitress Salary, US News, https://money.usnews.com/careers/best-jobs/waiter-and-waitress/salary (last visited Oct. 10, 2024).

[14] The term payroll taxes includes social security taxes, Medicare taxes, unemployment taxes, etc.

[15] The authors do not think this would work even if tips were not taxed, but the resulting burden on the IRS and state revenue agencies to audit would be significant.

[16] It must be noted that even with these proposals, most commentators will agree that many tipped workers do not include their cash tips as income on their tax returns, leading to the authors of this article to wonder if the benefit is as large as some people think.  Further, if a tipped worker goes from claiming $1,000 in tips to $15,000 in tips the next year, it begs the question whether they were filing accurate tax returns.

[17] This could lead to instances where the IRS would be forced to impose penalties for incorrect tax returns without an actual change in taxable income, which is undesirable from a policy and government efficiency perspective.

[18] For those states conforming to the Internal Revenue Code for determining their own income tax calculations, the burden would increase on their tax agencies as well.

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