Should Tips Be Exempt From Taxes?

Overview

Vice President Kamala Harris and former President Donald Trump’s tax policies differ significantly, but both have come out in favor of no tax being imposed on tips. Although the candidates have not shared many specifics about their policies, there already seems to be variance regarding qualifications and whether tip income would be free from all federal taxes. In addition, while both candidates claim their policy is intended to help working families, many economists and advocates for tipped workers argue it may not achieve that goal.

This policy brief first reviews current tax treatments of tip income and potential impacts of a no-tax-on-tips policy. It then summarizes the main arguments against such a policy and explores alternatives recommended by some advocates.

Current Tax Treatment of Tips

Tip income is subject to federal income and payroll taxes. Although details from candidates are currently limited, it seems that both candidates will exclude tips from income taxes. However, Trump and Harris may diverge regarding payroll taxes.[1]

Income Tax

The principles of tax law generally state that income from all sources is taxable unless there are exceptions. This applies to tip income, which is considered part of taxpayers’ gross income. Because taxpayers receive tip income through work, it is considered earned income (as opposed to, e.g., capital income).

Payroll Tax

Federal payroll tax is levied on wages, and tips are considered wages for payroll tax purposes. Payroll tax is used to finance Social Security (6.2% from both employer and employee) and Medicare (1.45% from each), which together make up the Federal Insurance Contribution Act (FICA) tax.[2]

Employers are responsible for their portion of the FICA tax. In the food and beverage industry, where tips are common, employers can receive a tax credit for FICA tax paid on tips that exceed $5.15 per hour.[3] Employers are also responsible for the Federal Unemployment Tax Act (FUTA) tax, which finances the federal unemployment insurance that provides payments to workers who have lost their jobs. This tax is 0.6% on each employee’s first $7,000 of earned income. In addition to their federal responsibilities, most employers also pay state unemployment tax. It does not appear that either presidential candidate intends to waive employers’ obligation to pay FICA and FUTA taxes.

Tax Administration Is Challenging

Although the rules for both income and payroll taxes seem clear, this does not mean they are easy to administer and enforce. The basic rule is that if a worker earns more than $20 in tips per month they must report the tip income to their employer, who is then required to withhold FICA tax on it.

The IRS notes that “the lack of complete information reporting and the cash nature of many tips suggest that tip income has a lower compliance rate than other wages and salaries and is harder to detect during an audit.” From a compliance perspective, it is also not cost effective to monitor potential underreporting of income when each transaction involves small dollar amounts. There are some indications that after the COVID-19 pandemic, the decline in popularity of cash payments may help recordkeeping and make it easier for the IRS to detect any underreporting. However, transactions that involve small dollar amounts are still significantly more likely to be conducted in cash.

The IRS’ National Tip Reporting Compliance Program (NTRCP) aims to help employees accurately report their tip income and assist employers in fulfilling their reporting requirements. The program allows participating employers to voluntarily enter tip compliance agreements with the IRS, which include conditions such as establishing procedures and reporting systems to ensure accurate reporting. As long as these requirements are met, the agency will not initiate tip audits. 

However, a 2018 Treasury Inspector General for Tax Administration (TIGTA) report points out that compliance was not ideal even for businesses with tip agreements. In 2016, 30% of businesses that had tip agreements with the IRS collectively underreported $1.66 billion in tip income. Noncompliance for businesses without tip agreements was even worse. The agency identified over 15,000 employers that underreported a total of $6.3 billion in tip income (an average of $420,000 per employer), with 676 of them underreporting by over $1 million each. In 2023, the IRS revamped the tip reporting compliance program, hoping to take advantage of the increased use of electronic payment systems at the point-of-sale.

Profiles of Tipped Workers

One reason that tipped workers garner attention is that they are typically low- to middle-income earners with limited workplace protections.[4] Several data sources have been used to identify tipped workers and their income profiles, including:

IRS — Data show that 6 million taxpayers collectively reported $38 billion in tip income in 2018. Among these taxpayers, the average reported tip income was $6,000 and the median income was $2,600. This pattern indicates that tip earnings were not evenly distributed across workers; a group of relatively higher income tip earners skewed the distribution toward the higher end of earnings.

The Budget Lab at Yale — Researchers used data from the Census Bureau to identify the number of tipped workers and their income, finding that there were about 4 million workers in the tipped occupations in 2023, 2.5% of all workers.[5] These workers tend to be concentrated at the lower end of the income distribution. The estimated median weekly wage for tipped workers was $538 (or $28,000 per year), compared with $1,000 per week for non-tipped workers. In fact, 37% do not pay federal income tax in 2022 due to their low earnings. In comparison, 16% of the rest of the workers do not pay federal income tax. However, most tipped workers still pay FICA tax.

Bureau of Labor Statistics (BLS) —Data from 2023 illustrate the average annual wage for these tipped occupations:

• Waiters and waitresses — $36,530 (around 2.2 million workers).
• Bartenders — $37,090 (711,000).
• Hairdressers, hairstylists, and cosmetologists — $41,780 (295,000).
• Manicurists and pedicurists — $36,480 (145,000).
• Couriers and messengers — $38,350 (72,000).[6]

In comparison, the average annual wage across all occupations and industries was $65,470.

The income differences for tipped workers across different data sources and estimates could reflect the different time periods (IRS data may be dated), different measurements (mean v. median), or the underreporting of income.

Main Arguments Against the Proposal

Equity

Concerns about this policy proposal often focus on equity and include the following:

Inequity for Others — By excluding one type of income from tax, workers with similar amount of earnings will pay different amount of taxes. It could be argued that because tip income is already more likely to go unreported or underreported, a certain level of disparity between tip and other income is already imbedded in the current system. Making tip income nontaxable will exacerbate the disparity.

Desirability — Others argue that the differential treatment could be desirable if there are meaningful differences between tipped and non-tipped workers such that favorable treatment of tipped workers is justified — even if this means violating the principle of treating workers of similar earning levels equally. However, it is not clear that this need has been fully established.

Benefits — Another concern is whether the no-tax-on-tips policy actually benefits lower-income tipped workers and raises their income. To the extent these workers do not pay federal income taxes, the policy provides little benefit to these workers. It does, however, help relatively higher earning individuals in this group.

Consequences — Excluding tips from payroll tax will benefit lower-income tipped workers to the extent they pay more payroll than income taxes. However, this will post heavy strains on the Social Security trust funds, which are already on precarious financial grounds.

Effect on Earned Income Tax Credit (EITC) — When considering the interactions of this policy with others, a major issue is the policy’s effect on the EITC, which is an important means-tested federal tax that benefit primarily targets low- to moderate-income working families. If the policy is designed in a way that tip income is not counted as gross income, a taxpayer may lose part of the EITC. For relatively higher-income tipped workers who are not currently eligible for the EITC, not counting tip income as gross income may lead to them qualifying for this credit.

Revenue

Trump first floated the no tax on tip idea in June 2024, and Harris followed in August 2024. Several policy research groups estimate how much tax revenue it would cost the federal government without considering how the policy-initiated behavioral changes will affect the cost (often known as “static analysis”). Given the limited policy details, these estimates are all preliminary:

Tax Foundation — The Tax Foundation’s estimate shows a revenue cost of $118 billion over 10 years for an income tax exemption, and it warns that behavioral effects could make the proposal more expensive.[7]

Committee for a Responsible Federal Budget (CRFB) — The CRFB estimates that under Harris’ framework, the cost of exempting tip income from income tax and raising the minimum wage would be $100 to $200 billion over 10 years. Under Trump’s guideline, the costs would be about $150 to $250 billion over 10 years.

The Budget Lab at Yale — Researchers estimate that an income tax deduction for tips would cost $107 billion over 10 years. This amount would reduce to $62 billion if the eligibility is limited to workers in the leisure and hospitality industries. If tip income is exempt from both income and payroll taxes, the cost would increase to $195 billion.

American Enterprise Institute (AEI) — While it does not provide modeling details, AEI states that exempting tips from income tax would cost at least $100 billion over a 10-year period. Researchers further note that if tips are also exempted from payroll tax, the cost would more than double.

Behavioral Responses

The revenue estimates seem to show costs in the $100 to $150 billion range, if tips are exempted from income tax. However, researchers express caution about the static nature of the analyses and indicate that the numbers are better viewed as a baseline or a starting point from which to gauge the policy dynamics. The resulting revenue differences — between static analyses and the dynamic ones that consider taxpayer behavioral changes as a result of the policy — could be significant, meaning that the policy could be a lot more expensive than expected.

From a modeling perspective, challenges arise from the lack of policy precedent. There are no prior experiences or observed taxpayer behaviors to reference. Another factor is that tipping is not entirely an economic activity; it could also be driven by personal preference, cultural norm, social convention, or geographic location. Possible behavioral responses are outlined below:

Change of Compensation Structure — Designating tip income with beneficial tax treatment would incentivize businesses to label or structure their compensation schemes favoring tips. This could involve moving the entire compensation from wages to tips or increasing the portion of tips in the total payment.

Definition of Tips — Although tipped workers are common in industries such as food and beverage, casinos, hair styling, parking, and nail care, they could work in any industry. There is a possibility that some traditionally non-tip industries could seek to classify their wage payments as tips. For example, commissions or bonuses could be considered “tips” because they are discretionary in nature.

Independent Contractors — The sharing economy is a burgeoning industry in which tips are a significant portion of the total compensation. The current proposal is most relevant to gig workers such as Uber drivers and food delivery couriers. One issue unique to this industry has been the debate regarding whether these workers are independent contractors or employees. In several states, they are independent contractors with employee-like benefits. It is not clear if the presidential candidates intend to include independent contractors in the no tax on tip consideration. However, exempting tax on drivers’ tips would likely remove the pressure on platform companies to provide higher pay or benefits, as consumers and the federal government would effectively increase drivers’ take home pay.

Overall, critics believe a policy of no tax on tips could be costly given the potentially sizable behavioral effects. While the potential results of this policy are unclear, the current system lacks safeguards to prevent possible abuses, such as altering compensation structures to emphasize tips.

Current Congressional Proposals

Three bills have been introduced over the last six months, addressing different details and tax treatments of tip income.

• No Tax on Tips Act (S. 4621) allows taxpayers to deduct cash tips received from gross income. It is designed as an “above-the-line” deduction, so non-itemizers can claim the benefit. Tip income is still part of the gross income and, therefore, will be subject to payroll taxes.
• Tax Free Tips Act of 2024 (H.R. 8785) classifies tips as gifts. As such, tips are not part of the gross income. This treatment would also exempt workers’ payroll tax liabilities.
• Tip Tax Termination Act (H.R. 7870) excludes $20,000 of tips from gross income for income tax purposes. This amount is also not subject to payroll taxes. This bill has two unique features: 1) it will sunset after December 2028, and 2) any reduction in revenue would be compensated by a transfer from the General Fund to the Social Security Trust Funds to hold these trust funds whole, or “harmless.”

Some argue that the no-tax-on-tips idea is more rhetorical than a realistic policy proposal, with only a few legislative session days remaining and a long to-do list. In addition to a crowded election-year agenda, the high price tag (in the $100 billion range over ten years) could also make the bill unpalatable. Even if this policy is considered in 2025, the discussion process will coincide with the negotiation over the expiring provisions of the Tax Cuts and Jobs Act (TCJA). This timing would put any expensive new provisions under heavy scrutiny.

Policy Alternatives

Why Seek Alternatives to Tipping?

Although the recent focus on tip-related policies has generated significant notice, advocates have long sought better pay for restaurant and hospitality workers. While advocates find the new attention promising, there may be better alternatives due to factors such as consumers’ tip fatigue and the unpredictability of tip income for workers. Some feel that the current proposals “would hurt service workers at lower-end restaurants, where tip income is relatively low.”

Consumers’ Tip Fatigue — During initial stages of the pandemic, consumers were generous in tipping delivery workers (for takeout or groceries) who continued working during lockdown. As the economy reopened, the shortage of workers and sustained public health concerns continued to maintain the level of tips. This led to an increase in tipping requests at businesses that typically do not solicit tips, as well as in the amounts suggested, often through automated prompts and higher recommended tips. However, as tip fatigue develops, the amount and frequency of tips given are likely trending lower. Anecdotal and opinion poll data indicate that consumers balk at the more widespread and frequent asks for tips, especially at locations that typically do not provide such services. Consumers’ tipping habits may also be affected when the economy cools off, reducing the amount or frequency of tipping.

Unpredictability of Tip Income — The major drawback of tip income for workers is its unpredictability. Although tips can be generous due to their discretionary nature, this does not happen often. Some advocates therefore suggest eliminating the subminimum wage (also referred to as “minimum cash wage”) for tipped workers. Currently $2.13 per hour, this rate was set in 1991 and has not been adjusted even as inflation increased significantly. Under the current system, if a tipped worker’s earnings are below $7.25 per hour (the current federal minimum wage) after considering tips, employers have to make up the difference. The federal minimum wage does not distinguish between tipped and other workers.

Alternative Approaches

Manage Tipped Worker Wages — The methods states use to handle wages for tipped workers vary, but they generally fall into three categories: 1) Require employers to pay tipped workers the state minimum wage before tips, 2) require employers to pay tipped workers a minimum wage higher than $2.13 per hour, and 3) adhere to the federal subminimum wage of $2.13 per hour for tipped workers.[8] Some advocates suggest that a better option is either for the federal government to eliminate the subminimum wage or for states to increase the minimum wage for tipped workers. 

Increase Earned Income Tax Credit (EITC) or Child Tax Credit (CTC) — Certain practitioners say increasing the EITC or CTC is a better way to boost household income for low- to middle-income workers. The biggest challenge is cost. The current CTC is $2,000 per child under the TCJA, which is set to expire at the end of 2025. If not extended, the CTC will return to its pre-TCJA level of $1,000 per child in 2026. Making the TCJA-level CTC permanent (at $2,000 per child) would cost more than $592 billion over a decade. Expanding the CTC to the pandemic level (from $2,000 to $3,600 per child) would cost $100 to $200 billion per year, or $1.6 trillion over the next decade. Identifying ways to raise revenue and make the plans less costly, if not deficit neutral, is critical for the success of this alternative.

Boost Standard Deduction — Some policy groups propose increasing the standard deduction as a way to reduce the tax burden on low-to middle-income taxpayers. This approach is not limited to a given industry or a certain type of income, although it could also be costly. According to the Congressional Budget Office’s (CBO) estimates, making the TCJA increases to the standard deduction permanent would cost $1 trillion over a decade. Further increasing the standard deduction beyond the TCJA level would undoubtedly involve a higher price tag.

Conclusion

Since its debut in June 2024, the idea of a no-tax-on-tips policy has generated discussion — garnering further attention after Harris endorsed the idea. Although both presidential candidates appear to have great intentions, many questions still need to be considered.

• Will payroll tax continue to be applied?
• Is it fair to workers at the same income level who do not earn tips?
• How significant will the behavioral responses be?
• Can safeguards be implemented against potential abuses?
• Is it possible to manage potential costs to the federal government?

The key question: Will this policy actually help the individuals it seeks to assist?

Notes

[1] Vice President Kamala Harris’ campaign website states that she will “end sub-minimum wages for tipped workers,” and “eliminate taxes on tips for service and hospitality workers” (“Support American Innovation and Workers,” A New Way Forward, Harris Walz, accessed October 7, 2024, https://kamalaharris.com/issues/). Former President Donald Trump’s campaign website states, “We will eliminate Taxes on Tips for millions of Restaurant and Hospitality Workers” (“2024 GOP Platform Make America Great Again!,” accessed October 7, 2024, https://rncplatform.donaldjtrump.com/).

[2] Taxpayers with income over $200,000 ($250,000, if married and filing jointly) also pay an additional Medicare tax of 0.9%. There is no employer share of this tax.

[3] For details about calculation of this credit, see Form 8846, Credit for Employer Social Security and Medicare Taxes Paid on Certain Employee Tips, IRS, accessed October 7, 2024, https://www.irs.gov/pub/irs-access/f8846_accessible.pdf.

[4] Some also argue the attention is because Nevada is a crucial state for both candidates, and 20% to 25% of workers in Nevada are in industries associated with leisure, hospitality, or passenger transportation: https://nevadaworkforce.com/_docs/Dashboards/CES-Industry-Dashboard.

[5] This number is later revised to 4% of families, or “tax units” under a different approach by the same organization (The Budget Lab at Yale, “‘No Tax on Tips’: Budgetary, Distributional, and Tax Avoidance Considerations,” September 16, 2024, https://budgetlab.yale.edu/research/no-tax-tips-budgetary-distributional-and-tax-avoidance-considerations). Both studies indicate the tipped workers constitute a small share of total workforce. These workers also tend to be younger than the workforce average and unmarried. For many of them, tip income is not their only or primary source of income.

[6] This is not an exhaustive list of industries for tipped workers. These are examples of industries most likely to have a large number of workers who receive tips.

[7] These estimates are from September 2024 for both plans (William McBride et al., “Kamala Harris Tax Plan Ideas: Details and Analysis,” October 16, 2024, https://taxfoundation.org/research/all/federal/kamala-harris-tax-plan-2024/). An earlier estimate from the same organization shows the revenue costs to be $107 billion. See also, 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] There are seven states in the first category: Alaska, California, Minnesota, Montana, Nevada, Oregon, and Washington. There are 30 jurisdictions in the second category and 18 in the last category. Some states in the second category (Idaho, Iowa, New Hampshire, North Dakota, Oklahoma, Pennsylvania, and Wisconsin) still follow the federal minimum wage of $7.25 per hour but have higher subminimum wage rates. Certain jurisdictions in the third category (Nebraska and Virginia, and Puerto Rico) follow the $2.13 federal subminimum wage but have a higher overall state level minimum wage.

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