When President Trump first floated the idea of exempting tips from tax, it probably sounded to many Americans like a good way to provide tax relief to working Americans. It certainly did to Vice President Harris, who soon after stated that she wanted to do the same. Unfortunately, the fact that both candidates like the idea does not mean it is a good one.
One reason is the fiscal impact. The deficit is already worryingly large, and one of the biggest consequences of this election will be who presides over a looming battle: which major tax cuts that are set to expire at the end of 2025 get extended? While this sunsetting package includes many good policies for taxpayers and the economy signed into law as part of President Trump’s signature tax reform package in 2017 and should be extended, that extension will add to the deficit unless it includes spending reductions elsewhere.
Exempting tips from federal income tax would represent a tax cut of at least $107 billion over the next decade, according to the Tax Foundation. That would only make the math harder for the more important fight over tax cuts that benefit all taxpayers, not just a small subset representing around 2.5 percent of workers. It’s not even a significant share of lower-wage workers, as just around four percent making salaries below the national average receive tips.
But whether or not a tip tax exemption would be well-targeted to taxpayers in need of relief is not the most significant issue with this proposal. The far greater problem lies in how businesses would respond to it: by changing as much employee compensation into tips as possible.
As anyone who has experienced the steady but unrelenting increase in prompts to tip checkout clerks knows, businesses already like tips very much. Tips allow businesses to lower their prices while still receiving the same amount of money from the customer. There’s no economic difference to a business between a transaction where a customer pays $15 for a product or $12 for a product and leaves a $3 tip, but the lower list price is more attractive to customers.
A federal tip tax exemption would only accelerate this trend. With such an exemption in place, a business could drive prices lower by transitioning as much of their employees’ compensation into tax-exempt tips as possible — and away from taxable wages. Employees could receive less gross compensation (i.e., wages plus tips), but still receive the same amount of after-tax income. Expect those increasingly obnoxious tip percentage suggestions at the bottom of your checkout screen to grow even larger.
And it may not just be the industries one would suspect that transition as much compensation as possible to tips. Highly-compensated individuals such as lawyers could begin encouraging their clients to leave tips to get some tax-free income. Heck, why not tip your landlord part of the monthly rent check?
All in all, there are far better ways to help lower-income individuals with their tax bills — such as, for example, making sure that the 2017 tax reform law’s doubled standard deduction and lower individual income tax rates are extended. Half-baked proposals for an arbitrary tax cut based on a specific form of compensation should be left in the kitchen trash.
Andrew Wilford is the Director of the Interstate Commerce Initiative with the National Taxpayers Union Foundation, a nonprofit dedicated to tax policy research and education at all levels of government.
The views and opinions expressed in this commentary are those of the author and do not reflect the official position of the Daily Caller.
