What If Tips Didn’t Get Taxed?

In a seemingly rare moment of bipartisan agreement, Vice President Kamala Harris followed her opponent in the 2024 presidential election, former President Donald Trump, by proposing that income earned from tips and gratuities by service and hospitality workers should be exempt from federal taxes. 

While little has been done to pass legislation on this, the mere fact that both presidential candidates are proposing a similar change suggests that a tax-free-tips world might be on the horizon. Here’s how income from tips is currently taxed, and what that tax-free-tips world might look like.

Taxing Tips

Here’s how §61 of the Internal Revenue Code defines: “Except as otherwise provided in this subtitle, gross income means all income from whatever source derived.” This spans everything from your regular paycheck, to investments, to earnings from sports gambling—even $20 found on the sidewalk. All earnings that meet that definition should appear on your federal tax documents, and you should pay taxes on all this income. 

This broad definition includes tips. Tips are commonly earned in industries like hospitality and entertainment. In the U.S., restaurant diners typically add 20% to the cost of the meal to compensate the server and their team for their effort. In a casino, it’s customary to tip your dealer. Whether these tips come via cash or an electronic payment, the Internal Revenue Code defines the money received as income, and requires the recipient to report and pay taxes on it.

The Pluses of Subtracting the Tip Tax

It’s not uncommon for proposed tax cuts to surface in an election year. At times, politicians have been accused of using them to enhance their chances of winnings. 

Whether they swing elections or not, tax cuts always create winners and losers. And the winners in Harris and Trump’s proposals are those in the service industries. Many people in these jobs earn lower compensation. According to ZipRecruiter, the average pay for a restaurant server in North Carolina is $23,971. Even career servers who work in higher-end establishments only earn between $54,000 and $97,000.

Reducing taxes for these lower- and middle-income earners will raise their purchasing power. A policy that does that may be particularly important in an election year when swing states like Arizona and Nevada (both of which have very large service industry sectors) could determine the outcome of the election.

It’s worth noting that neither Harris nor Trump has been clear about which taxes they’d exempt tips from. We’ve been addressing payroll taxes here, but employees and employers are also each subject to Social Security and Medicare taxes, totaling 7.65 percent of tip income. If the tips end up being completely “tax-free”, this means that both employees and employers may save money on employment taxes. 

Writing this change into tax law would be fairly simple. The United States often taxes different types of income at different rates. For example, individuals who sell stock at higher prices than they bought have to report the difference as income. These capital gains are taxed at a lower rate than other types of income. The same is true for dividends received from owning shares in a corporation. Furthermore, income received from interest on a municipal bond is tax-free—not unlike the proposed treatment for tips.

Potential Drawbacks of Making Tips Tax-Free

Basic economics suggest that a change like this will have unintended consequences. For example, by increasing workers’ effective income (via a tax reduction), a tax-free-tips policy could encourage employers to reduce pay or slow pay increases until a new equilibrium is reached. Another economic concern would be that raising the purchasing power of a large group of individuals could fuel skyrocketing inflation, much as the economic stimulus provided during the COVID-19 pandemic drove the inflation of the early 2020s.

Furthermore, while the law might be relatively simple to enact, the potential for loopholes and exploitation may be insurmountable. Consider, for instance, a self-employed person who owns a business that receives payments from customers for services. Prior to the elimination of the tax on tips, they paid themself a $1 million annual salary from a small, solely owned corporation. After tips become tax-free, they could attempt to reclassify their income as a salary of $100,000 and a tax-free tip of $900,000. 

That’s an extreme example, but consider another from an industry where payroll and other income mix more frequently. A hair stylist often charges a standard fee for a trim and also accepts tips. There would be little to stop them from altering their payment structure to classify all compensation as tips. 

Policymakers will need to be very careful to ensure that loopholes do not get exploited. This careful language would likely include defining the affected industries and limiting the amount that can be tax-free.

Another potentially substantial unanticipated drawback for employees is the eventual effect on their Social Security payments if tips go totally “tax free.” Many service industry workers receive a substantial portion of their income in tips. Right now, all income they report goes into the pool of credited income that will eventually determine how much they’ll draw in Social Security payments after retirement. The amount of Social Security retirement benefits is based on the highest 35 years of past earnings. 

That might not be a big deal for a college student waiting tables part-time. But for older or full-time service employees removing tips from Social Security earnings could substantially reduce their retirement income. 

Given how vague the candidates have been about which taxes they’d exempt tips from, it’s not clear how tips will be treated for Social Security. If lawmakers do eventually make tips tax free for federal income tax purposes, they need to put significant thought into whether they will also be free from employment taxes and therefore excluded from “paid in” Social Security income. 

The biggest drawback of a tax-free-tips plan may be its relatively small impact on employees. Consider the North Carolina server making $23,971 a year after the standard deduction ($14,600 in 2024): they’re only paying $937 in federal income taxes in 2024. Assuming all their income comes from tips, the most that they’d make from federal tax savings would be $937. Waiving employment taxes, too, would give them another $1,834. Most likely, that server would also have some non-tip income, so tax savings would be even lower. 

While this extra money would be warmly welcomed by many, the recent rise in the costs of housing, transportation, and basic goods and services seemingly dwarfs its value, especially in light of the other downsides of tax-free tips. 

Future Considerations

Policymakers want to offer simple proposals that would enhance economic conditions for lower- and middle-class taxpayers. Exempting tips from taxes is a promising possibility, but there are other economic levers they can consider. For instance, raising the minimum wage or increasing tax credits for lower-income taxpayers could be similarly effective. While each of those options has its own set of drawbacks, they’re certainly paths that can and should be considered.

Nathan Goldman and Christina Lewellen are associate professors of accounting at the Poole College of Management.