How to design a tax exemption for tips that is workable and fair
The Harris and Trump campaigns have both arrived at a common, and fundamentally populist, policy idea: exempting tips from federal income tax. These proposals have garnered almost uniform opposition from economists, policy experts and commentators — and for good reason.
A tax exemption for tips could favor some workers over others, encourage abusive gaming of the system on a broad scale and fail to benefit those who earn least. The loss in revenue could exceed $200 billion over 10 years.
Moreover, a policy of “no tax on tips” has scant precedent in tax policy. Isolating a tip exemption’s negative effects would require complex guardrails, crafted under the political pressure of a headline-grabbing campaign promise. Overburdened employers and the IRS would have to police these limitations. Novel ideas risk costly missteps.
“No tax on tips,” however, does have a surprising parallel under current law. The Trump administration’s signature legislative achievement, 2017’s Tax Cuts and Jobs Act, gave a flat 20 percent deduction for “pass-through” business income. Although intricate guardrails limit the pass-through deduction’s benefits, it still favors some businesses over others, rewards intensive tax planning and primarily helps those who earn most — at a cost to the government of more than $40 billion annually.
The pass-through deduction’s problems do not mean that Harris and Trump should abandon “no tax on tips.” Instead, the pass-through deduction establishes a basic template for and shows the challenges faced by a tax exemption for tips. In particular, the pass-through deduction’s fixed-percentage benefit, income caps and occupational limitations each could improve a new tip exemption.
Among workers, tips vary as a percentage of income. Servers at fine-dining restaurants earn proportionately more in tips than staff at fast-casual establishments. Tip rates, as well as tip pooling practices, differ across cities and states. Race and sex also affect the tips workers receive. Like the pass-through deduction, any exemption for tips could address these disparities by excluding a fixed percentage of tipped workers’ total earnings, even if that percentage does not reflect tips actually received.
Both candidates trumpet tip exemption as a boon for service workers, many of whom are lower- and middle-income. Delivering benefits to these workers is tricky, since many pay little or no income tax. The pass-through deduction imposes phased-in restrictions on high-income taxpayers’ ability to claim benefits, and some reform proposals would deny the deduction altogether for high-income individuals. Comparable limitations would help target the benefits of a prospective tip exemption to those most in need.
A tip exemption also would encourage employers and customers to characterize compensation as tips, even in industries without a tradition of tipping. For example, clients might pay a portion of investment managers’ fees as discretionary “tips,” letting the clients share in their managers’ tax savings through lower total fees. To curtail such game-playing, the pass-through deduction categorically denies benefits for high-income claimants in certain occupations. A similar strategy could curb tax abuse for a tip exemption.
The pass-through deduction has serious downsides. Fixed-percentage benefits operate arbitrarily when applied to individual workers. Quantitative income caps and phase-ins sometimes miss their mark. Occupational limitations create definitional headaches without alleviating the burdens of enforcement. Taxpayers and their advisors may devise fresh tax tactics for gaming the system.
Harris and Trump could avoid many of these design issues by thinking bigger. At its core, a tip exemption addresses the question of who pays what in our tax system. Lower- and middle-income service workers contribute too much, and are left with too little, after taking into account income, payroll, sales and other taxes.
The problem is that an effective tip exemption requires a large legal infrastructure. In this respect, the pass-through deduction serves as both a model and a cautionary example. A more direct (and efficient) approach would rethink tax rates as they apply to earners across the income spectrum.
The candidates could fulfill their campaign promise and also engage in this comprehensive rethinking. In a forthcoming academic article, I demonstrate that making a targeted tax benefit universal can have the same effect as repealing that benefit. This equivalence depends entirely on how lawmakers adjust tax rates to account for the broader or narrower benefit. Either everyone benefits, or no one does, with tax rates adjusted so that everyone pays their fair share.
From a policy perspective, the pass-through deduction and “no tax on tips” share commonalities. Neither has a well-established policy rationale, and both are very difficult to implement. Because the pass-through deduction expires after 2025, the next administration will have to address both of these politically fraught topics.
One solution is to expand the pass-through deduction to all employees. Tipped workers would receive a flat 20 percent deduction for their total earnings — a substantial step towards tip exemption. But other workers would benefit similarly. Lawmakers could adjust tax rates so that people of all incomes contribute appropriately to the costs of government.
The effects of this change could be commendable. A universal benefit would not favor some workers or business owners over others. Similarly, tax gaming would offer no edge under a benefit that applies to everyone. And a revised rate schedule would treat all taxpayers fairly while also raising sufficient revenue.
“No tax on tips” may offer something that Americans want, but what Americans need is a holistic reconsideration of how our tax system advances equity across society. If a tip exclusion leverages this larger conversation, the proposal’s critics will have few complaints.
Sloan G. Speck is an associate professor of law at University of Colorado Law School.