Momentum Builds for Tax-Free Tips
Legislation filed in both houses of Congress shows how tip income could become untaxed. But questions still remain.
During the election, both President Donald Trump and former Vice President Kamala Harris garnered bipartisan support for tax relief on hospitality workers’ tip income.
At the time, it was uncertain whether these proposals would move forward or how they might translate into legislation. The picture is becoming clearer, as bills have now been proposed in both the U.S. House and the Senate. There still appears to be broad bipartisan support for some tax relief on tip income, although the details of the chambers’ proposals vary a bit.
The bills being proposed now are very specific and have limitations. The primary House Bill, known as the “No Tax on Tips Act,” would include tips in a taxpayer’s gross income, but it would allow a deduction of up to $25,000 for qualified tip income, thereby reducing taxpayers’ total income subject to federal tax. This deduction would be “above-the-line” (rather than an itemized deduction), allowing more taxpayers to receive this deduction.
The main House bill would require lawmakers to publish a list of qualified occupations. Presumably, those would be limited to jobs that customarily receive tips (such as stylists and waitstaff). Taxpayers with compensation above a certain threshold would not qualify for the deduction.
A Senate bill largely mirrors the House one. The proposals would only reduce federal tax on tips, leaving Social Security income unaffected.
Is this “good” tax policy?
While theorists differ in their specific standards for evaluating taxes, several standards commonly emerge. They include equity, sufficiency of tax revenue, simplicity, and economic efficiency.
The equity standard refers to how the tax is distributed over the array of affected taxpayers. There are two facets of equity. Vertical equity measures the relative tax burden at various income levels. By this standard, a “good” policy would cost high earners more in taxes than it costs lower earners.
Horizontal equity deals with how a tax affects people who are in similar financial situations. By this standard, a “good” policy would equally affect two earners in roughly similar jobs and with roughly similar incomes.
The newest proposals appear to increase vertical equity. Because earners above a certain income level wouldn’t qualify for the tip income exemption, the House and Senate proposals would target taxpayers on the lower end of the income spectrum.
Horizontal equity is another story. Consider two employees at the same restaurant who earn the same gross income. One is a server, and the other is a cook. This legislation would mean that only the server would have the opportunity to receive up to $25,000 of tax-free income, even though they have the same level of income as the cook. Exempting tips from taxation decreases horizontal equity because it only reduces tax for certain job types.
The sufficiency standard of tax revenue is another important consideration. Any time there is a tax cut, tax revenues go down. By balancing the tip deduction with an overall income limit, the House and Senate proposals do somewhat limit the adverse effects of tax revenue collections. Many tipped employees do not make enough to pay federal income tax, so this legislation would not reduce tax revenues for this group. Moreover, experts also estimate that tips are under-reported to the IRS, so some tip income goes untaxed due to tax evasion. Other experts estimate the overall tax revenue decline at around $100 billion over the next decade.
Simplicity of tax collection and compliance is a third concern. Employers in relevant industries must already break out tip income on quarterly employment tax filings, W-2s and other mandatory forms, so the additional compliance cost for employers is unlikely to be substantial. The same is true from the government’s perspective.
Finally, this tax policy change could have adverse effects on economic efficiency. Economically efficient tax policies shouldn’t change people’s behavior. Making one type of income nontaxable might shift the demand for employment toward that type of income. As a result, affected industries (restaurants, for example) might have difficulty hiring non-tip employees (cooks or dishwashers).
The affected businesses might also have to raise wages for roles that don’t generate tip income. For restaurants, which already operate under small profit margins, that’s a significant constraint.
On the flip side, the hospitality industry was heavily affected by the Great Resignation, and many restaurants still struggle to attract and maintain workers due to increasing wage demands. Reducing tip income tax could incentivize some people to re-enter these jobs.
This tax policy change could also affect consumer behavior. Imagine a hairstylist who shifts their pricing because tips become nontaxable. What was a $200 service could be priced at $100, plus a mandatory $100 tip. Such a shift could frustrate consumers who are already tired of tipping.
Untaxed Tips: Winners and Losers
During the presidential campaign, the candidates’ proposals were rather vague and did not specify many details about how the tax-free tips would be implemented. This notion raised important concerns because if all tip income became nontaxable without “guardrails,” we could see some bizarre economic behavior and taxpayer consequences. While the new proposals added these guardrails, clarifying the viability of such a law being passed and enacted, there are still many questions about the ultimate economic effects.
As with any tax policy, there are winners and losers. The winners of the proposed policies appear to be individuals at certain income levels working in industries where tipping is customary. The primary potential losers are taxpayers in non-tip jobs with similar income levels, business owners who could face frustrations and changes in employment demands and the economy as a whole due to potential reductions in tax revenues.
Policymakers should carefully consider the costs and benefits as they move forward and decide whether to allow these proposed deductions for tip income.
Christina Lewellen is the Dean’s Scholar and an associate professor of accounting. She teaches principles of taxation at the undergraduate level and her graduate teaching focuses on tax planning to help business owners structure operations in a tax-efficient manner. Her research primarily focuses on corporate taxation.
Nathan Goldman is the Dean’s Scholar, University Faculty Scholar, and Park Faculty Scholar. He is an associate professor of accounting, and his teaching and research focus on corporate taxation.
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