Yes, We Should End Taxes on Tips

President Donald Trump has announced (several times) that he will end the taxation of tipped income. There is a lot to celebrate whenever a tax goes away—but the devil is in the details.

First, the numbers. There is $36.4 billion in reported tip income in the United States annually—emphasis on “reported,” as many cash tips escape the notice of the IRS. Of that, $24.2 billion is from full-service restaurants. If you figure that the average tipped service employee is in the 12 percent tax bracket, that’s about $4 billion to the IRS, in the context of a $6.9 trillion budget. And by the way, the IRS requires you to keep track of your tips if you make $20 or more in tips in a calendar month. All the paperwork, all the hassle, all the audits, just for $4 billion to the federal government, an amount it will burn through in about 18 hours.

Trump is right to want to get rid of taxes on tips, primarily because it’s a heavy paperwork load and it generates practically no revenue. Promising to get rid of it was a downright genius political move because it appealed to the 4 million workers in tipped occupations, and he was buying those votes for practically nothing.

There are, however, a few flies in the ointment. When people think about tipped occupations, they usually think of the waitress getting $2.50 in tips off a country ham at Waffle House. It should be pointed out that there are some tipped occupations that make well into six figures—especially in Las Vegas. Casino hosts, doormen, bottle girls, strippers, and sex workers can make multiple six figures in tipped income and enjoy a high standard of living. So if you were class-warfare-minded, the unintended consequence of this is that it will make some already-rich people richer. (But I don’t think we care about that—good for them!)

The other potential downside of eliminating taxes on tips is that, naturally, people are going to try to arbitrage the system and treat actual wages as tip income. If you can use your imagination, you will probably see that tipped occupations will explode after the tax is abolished. Not that civil disobedience when it comes to taxes is necessarily a bad thing, but the IRS will probably be spending most of its time determining whether reported income is actually tip income or not—which is probably a marginally better use of its time than making people track their cash tips in a notebook. The foregoing is also true for eliminating taxes on overtime.

It will be an interesting economic experiment to see if tips decrease after tax on tips is eliminated. If you knew that your server was making 12 percent more on an after-tax basis, would you tip 12 percent less? Some people would. About five years ago, there were heated discussions online as to whether America should do away with its tipping culture and be more like Europe, where service jobs are salaried professions. If you’ve been to Europe, you probably know that service can be indifferent, at best. In America, tips can be arbitrary and inconsistent—there are good tippers and bad tippers, and oftentimes, there is little to no correlation between the quality of service and tip income on a nightly basis. But over time, conscientious, friendly servers do earn more.

The worst thing about taxing tips is that cash tips are more or less on the honor system—so it’s a cat-and-mouse game between the tipped employee and the IRS as to how much income one could reasonably not report before getting an audit. This is one of the motivations for the push toward a cashless society, and perhaps central bank digital currencies, to give the government electronic records of everything. 

It should also be pointed out that tipped employees were frequently the target of IRS audits, haggling over a few hundred dollars in taxes. In recent years, we learned that the IRS disproportionately audited low-income taxpayers compared to high-income taxpayers—the IRS staff simply did not have enough smart and savvy agents who could comprehend the complexity of the 1,000-page tax return of a centimillionaire. Thus, the burden of the audits fell on the servers who had underreported their tips by a negligible amount—all for inconsequential gain.

Ending the tax on tips not only puts more money in the pockets of service employees but also unburdens them from an onerous tax enforcement regime. Taxes on tips raise practically no revenue and are a make-work project for thousands of IRS agents. Trump gets one right.

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