What’s all the fuss about tips and taxes?

By Anna Helhoski | NerdWallet

When electioneering, the best pledges are catchy enough to get stuck in a voter’s head. During this election, “no tax on tips” seems to be the phrase fitting that bill.

Both presidential candidates are embracing the promise to exempt workers from paying taxes on their tips. But the problem with no-tax-on-tips proposals, experts say, is that they’re clearly a bid for votes rather than a substantive solution to address the fundamental needs of tipped workers.

“This wouldn’t help very many workers, and it could actually be very harmful to millions more, with the real benefits of this policy change going to employers and the wealthy at the expense of working people,” says David Cooper, researcher from EPI Action, a nonpartisan research and advocacy organization.

How a no-tax-on-tips promise entered the election

On June 9, former President Donald Trump made a promise to end taxes on tips in front of service workers in Las Vegas. Last weekend, in Las Vegas, Vice President Kamala Harris made a similar pledge. It’s no coincidence that both candidates made the announcement in Las Vegas — leisure and hospitality is the dominant industry in the metro area, Bureau of Labor Statistics data shows.

On Monday, White House press secretary Karine Jean-Pierre said that President Joe Biden also supports eliminating taxes on tips for service and hospital workers, as well as raising the minimum wage.

The policy is undeniably appealing for tipped workers and the unions that represent them. After all, who doesn’t want a tax break when they can get it? Experts say the message to voters may be effective, but the policy is less likely to be.

“I’d say, thumbs down to the policy proposal; it’s bad tax policy,” says Kyle Pomerleau, a senior fellow studying federal tax policy and reform at American Enterprise Institute, a right-leaning think tank.

How do tips factor into wages?

Tipped workers are some of the most visible workers: They’re taking your coffee order, cutting your hair, serving your meals in restaurants, delivering your groceries and ridesharing you around town. And yet, the Budget Lab at Yale University estimates there are only about 4 million workers in tipped positions in 2023 — about 2.5% of the entire U.S. workforce.

The most typical tipped work is in the service and hospitality industry. Tipped workers also tend to be younger than the rest of the working population — 20 to 34 years old, according to Yale Budget Lab.

In order to qualify as a tipped worker, you must earn more than $20 per month in tips. In tipped positions, workers must receive a subminimum wage, also known as a cash wage, of $2.13 per hour. A subminimum wage is combined with tips in order for workers to earn at least the federal minimum wage of $7.25 per hour. If an employee earns a subminimum wage plus tips less than $7.25 per hour, an employer must make up the difference.

There’s also something called tip pooling that’s often done in restaurants; it’s where the front of the house (servers and bartenders) share their tips with each other, as well as with the back of the house (such as cooks and dishwashers). In this scenario, all employees who receive pooled tips — including the workers who earn the tips — must make at least the federal minimum wage, according to the Department of Labor.

It’s unclear how often restaurants properly adhere to wage rules because tipping is notoriously underreported. Although, that’s less of an issue now since most people pay electronically and don’t leave cash tips as often anymore, says Howard Gleckman, senior fellow in the Urban-Brookings Tax Policy Center at the Urban Institute.

How do taxes on tips work?

Tips are considered taxable income. But not all income is taxed; that depends on the amount a worker actually earns.

Median weekly wages, including tips, are $538 among tipped workers, compared to a median of $1,000 among non-tipped workers, according to 2023 estimates by Yale Budget Lab. Many tipped workers earn so little they already aren’t required to pay federal income taxes; Yale Budget Lab estimates this is the case for about 37% of tipped workers.

It’s likely only a small sliver of the tipped worker population would get the tax advantage that Trump and Harris propose — and that’s without knowing what specific income limits would be set by either candidate’s plan.

“Think about somebody who is a server at ‘Bob’s Diner’ — it has a $9.95 special and [the server] is going to get two bucks,” says Gleckman. “If you’re a server at some fancy downtown steakhouse where dinner is $200, you’re going to get 40 bucks, right? So for those higher income servers, this [policy] can make some difference. But for most people, it won’t really matter at all.”

There’s another important distinction about tips and taxes: Even when workers don’t have a federal income tax obligation, workers and their employers must pay federal payroll taxes, which fund Social Security and Medicare programs. That also means they must continue to report tips, even if federal taxes on tips are eliminated; also, the proposals would not affect state income tax requirements.

Neither Trump or Harris has specified whether their proposals would apply only to the federal income tax. But if the No Tax on Tips Act, introduced by Sen. Ted Cruz (R-Texas), is any indication, the exemption would likely only apply to federal income taxes.

How much would no-tax-on-tips save a typical tipped worker?

Tip earnings are hard to characterize since the amount varies drastically based on the type of service that workers provide, as well as local minimum wage laws. But the Tax Foundation offers an example: Say a server earns $19,000 per year in wages plus $15,000 in tipped income. Their adjusted gross income is $34,000. They take a standard deduction of $14,600, which leaves them with $19,400 in taxable income. Under this example they owe $2,096 in federal income taxes.

With a no-tax-on-tips policy in effect, their adjusted gross income is $19,000 since the $15,000 income in tips isn’t considered taxable. They take a standard deduction of $14,600, which leaves them with $4,400 in taxable income. Under this example, their tax liability is $440. It’s the difference of $1,656 from the previous example.

As the Tax Foundation points out, a cashier who makes the same $34,000 — without tips — would have the same $2,096 federal tax liability in either scenario, and so would be paying vastly more in taxes than the server under a no-tax-on-tips policy.

Experts say no taxes on tips is bad policy

Suffice to say, tax and wage experts are unimpressed with the no-tax-on-tips proposal.

“This wouldn’t help very many workers, and it could actually be very harmful to millions more, with the real benefits of this policy change going to employers and the wealthy at the expense of working people,” says Cooper.

Here are some reasons why experts say exempting tips from taxes could have negative repercussions, depending on how the policy is structured.

Social programs and other tax benefits could be impacted

If a no-tax-on-tips proposal includes an exemption for the payroll tax in addition to the income tax, it could impact both worker eligibility for Social Security and Medicaid, as well as the solvency of the program itself, says Cooper.

This scenario isn’t necessarily likely. Even though Trump has not specified if his proposal would apply to both the federal income tax and the payroll tax, Cruz’s No Tax on Tips Act applies the exemption only to the federal income tax. It’s difficult to see Harris applying the exemption to the payroll tax.

But depending on how the law is written, no-tax-on-tips could make it more difficult for workers to get other tax benefits like the earned income tax credit or the child tax credit, experts say.

“If you’re a household with children, those credits phase-in with earned income, meaning that they are larger the more income you earn, up to a certain point,” says Pomerleau. “But if you were to structure this tax exemption as an exemption from adjusted gross income, it would directly interact with the earned income tax credit in the child tax credit and reduce those benefits for households.”

No matter what, says Pomerleau, no-tax-on-tips would add tax complexity for a population of tax filers that, generally, do not have access to accountants to help them through the process. That could result in more workers not filing taxes or not being able to access the benefits they are eligible for.

High earners could find a loophole

A tax exemption on tips leaves open the possibility of exploiting the system. Some in high-income positions like lawyers, for example, could restructure how their earnings are reported to avoid paying taxes on a portion of their income.

“You could envision a lot of scenarios where this would be really grossly abused by highly paid individuals,” says Cooper.

The Harris campaign told The Washington Post that, under her plan, the tax exemption would only apply to workers who earn below a certain threshold in select industries. This would prevent high earners in nontraditional tipping positions from gaming the system. There is currently no bill from Democrats in Congress that matches Harris’ plan.

Trump’s proposal and the No Tax on Tips Act from congressional Republicans doesn’t narrow industry eligibility or impose income limitations.

It could reduce employers’ need to raise wages

The tax benefit presents a double whammy benefit to owners: a tax benefit that appeals to workers and an opportunity to save money by shifting the pay burden from owners to consumers.

“It’s a win-win for restaurant owners, hotel owners, like, for example, Donald Trump,” says Gleckman. “But it’s much more ambiguous and much riskier for tip workers, particularly low-income workers.”

Cooper says this policy won’t incentivize employers to raise raises for workers because there’s a tax benefit inherent to the job. But it could incentivize businesses to reclassify certain positions as tipped occupations.

“The tipping system, as it currently exists, is rife with wage theft and discrimination,” says Cooper. “It opens up workers to abuse from customers and colleagues because they feel like they have to tolerate bad behavior, lest they put their kids at risk. So this [policy] would grow a system that is problematic in a lot of ways and spread it to more occupations. That’s not something that we should be incentivizing.”

The deficit would increase, although not substantially

Tax cuts lead to a decline in revenue, which could, over time, exacerbate the federal deficit; it’s currently about $1.52 trillion, according to the U.S. Treasury. The Committee for a Responsible Federal Budget estimates the cost of exempting tips from federal income tax would be $100 to $200 billion over a decade. If tips are also exempted from payroll taxes, the total could run to $250 billion.

If the policy makes tips exempt from the payroll tax, it would have broader repercussions for Social Security and Medicaid programs, experts say.

“These programs are already facing a fiscal shortfall and will need to be dealt with, in as little as ten years,” says Pomerleau. “If they were to remove $38 billion, potentially from the face of Social Security and Medicare, I would accelerate this problem.”

It could exacerbate tipping backlash

As the CRFB notes, what’s not included in its calculations are changes in tipping behavior, which could result in consumers giving less than they do now if they perceive tipped workers as getting an unfair tax advantage.

A backlash to tipping culture has already resulted in 7% lower tipping among service-sector workers from November 2022 to November 2023, according to a payroll analysis by Gusto, a payroll provider.

It could fuel worker resentment

On the flip side, excluding certain tipped jobs by field or income could stir the pot among workers and the unions that represent them.

Cooper says, “Why would we be giving preferential income tax treatment to this very small subset of workers when there are lots of other hard working, low-paid workers — people providing daycare, childcare, eldercare — that this would do nothing for?”

Gleckman says the policy violates a “cardinal rule of good tax policy,” which is to tax people making the same income at the same level. “I’m not sure I quite understand why a low wage worker somehow should enjoy more benefits than a low wage worker of another kind who’s getting the same income,” says Gleckman. “If you really care for a bunch of low wage workers, there are plenty of other things you could do.”

Unions and businesses groups support no-tax-on-tips

Despite criticism of the no-tax-on-tips proposal, it would benefit workers who are eligible. Adding limitations by industry and income could prevent the exemption from being a regressive one.

Shortly after Harris’ announcement, Culinary Union Local 226 in Nevada endorsed Harris for president and lauded the proposal without acknowledging Trump’s. The union, along with the Bartenders Union Local 165, represents 60,000 workers in Las Vegas and Reno. The Culinary Union argues that the tax exemption could help millions of workers that earn a subminimum wage.

“The fact that many companies pay tipped workers across the country $2.13 an hour is outrageous and ending taxes on tips for service and hospitality workers would significantly help millions of workers provide for their families, including in Nevada,” the union wrote in its press release endorsing Harris.

Businesses that employ tipped workers also support the plan. At least, Cruz’s plan, which would not limit the exemption by industry and income. Two of the biggest associations for the top tipped industries — the National Restaurant Association and the Professional Beauty — both endorsed Cruz’s proposal.

“Tipped employees are a critical part of the restaurant industry, and anything that strengthens their economic condition is a positive for them,” said Sean Kennedy, executive vice president of public affairs for the National Restaurant Association in a press release announcing Cruz’s bill. “The ‘No Tax on Tips Act’ would provide immediate tax relief for more than 2.2 million restaurant employees and their families, putting more money in their pockets at a time when we’re all feeling the squeeze of higher prices.”

Ending the subminimum wage would pack a bigger punch

During the campaign rally in Las Vegas last weekend, when Harris made her promise to end tax on tips, she also said she would raise the minimum wage. What she didn’t promise to do is eliminate the subminimum wage, which would have a bigger impact on tipped workers.

“Why not do something like raise the minimum wage if you really want to improve outcomes for tipped workers in the United States?” says Cooper.

The federal minimum wage for all workers has been $7.25 per hour since 2009. However, 30 states plus the District of Columbia have set minimum wages above that amount. Again, the federal subminimum wage is $2.13 per hour. Right now, 36 states have set minimum wages for tipped workers below the federal minimum wage of $7.25 per hour.

The tipped workers who earn the most, nationwide, are in Los Angeles ($16.78 per hour); Seattle ($17.25 per hour); and New York City, where tipped workers earn $15 per hour with the exception of delivery workers, who earn a minimum of $17.96 per hour.

Other places have eliminated the subminimum wage practice altogether. So far six states have banned subminimum wages for tipped workers, including Alaska, California, Minnesota, Montana, Oregon and Washington.

“It is outrageous that over a million workers in this country are not guaranteed a fair minimum wage in 2024,” the Culinary Union 226 wrote in a release endorsing Harris’ proposal. “Employers across the nation need to take responsibility for paying a real minimum wage and Congress must ensure it.”

Beyond raising the minimum wage, there are other levers that could be pulled to help low wage workers, experts say. That includes expanding income supports like the child tax credit, the earned income tax credit or Medicaid.

Anna Helhoski writes for NerdWallet. Email: anna@nerdwallet.com. Twitter: @AnnaHelhoski.

The article What’s All the Fuss About Tips and Taxes? originally appeared on NerdWallet.