As the election cycle progresses, it is becoming clearer that both candidates are pandering to buy votes, particularly when it comes to tax policy. Last month, Trump proposed exempting Social Security from income tax as a way to buy senior votes, which I criticized as a budgetary blunder. There is another tax exemption under fire: exempting tips from taxes. Why bring up this exemption?
In part, Nevada has a disproportionate amount of workers who work for tips and happens to be more of a swing state this election cycle. Trump proposed the idea back in June, saying that people who earn their money should keep their money. Harris saw the political strategy enough where she decided to copy Trump's idea last week. This is being passed as tax relief either for working families or boosting take-home pay for "the little guy." It makes political sense, especially since more industries are trending towards tipping since the COVID pandemic. Forget for a moment I scrutinized the practice of tipping in 2014 and pointed out how it does not make economic sense. This policy to exempt tips from income and payroll taxes comes up short for a few reasons.
It is poorly targeted policy. This criticism is similar to one I have for the minimum wage. Minimum wage is not effective at poverty reduction because it targets individual income, not household income. For one, only 2 percent of workers work for tips. This figure is 5 percent for the bottom 25 percent of earners. Leaving most low- and middle-income earners out is not the only issue. According to Yale University's Budget Lab, 37 percent of tipped workers do not pay income tax because they do not earn enough to reach the threshold. If that is not enough, customers might react by reducing their gratuities, thereby hurting low-income workers in the process.
A shift towards tip income could create problems. How much will tip income increase? That is a good question. High-end earners, such as financiers, could see it as a loophole to recategorize their income as tips and shield it from taxation. By making one type of income taxable (e.g., wages) while making another type of income tax-exempt (e.g., tips) could incentivize a tip-based payment approach. Some tipping industries could rely on it, whereas other non-tipping industries could become tipping industries. Providing this carve-out has no clear rationale while creating real potentials to cause greater distortion in the tax code. In the worst-case scenario, it could put downward pressure on service sector wages.
This exemption would pile onto the federal deficit. In June, the bipartisan Committee for a Responsible Federal Budget (CRFB) calculated that Trump's proposal would reduce federal revenue between $150 billion and $250 billion between fiscal year 2026 through fiscal year 2035. The Right-leaning Tax Foundation had a low-bound estimate of $107 billion over a decade. Since Harris is looking to have tips remain subject to payroll tax, the CRFB estimates that Harris' version will have about half the impact on the federal budget as Trump's version. Neither candidate has proposed corresponding spending cuts to offset the tax reduction, which means that the U.S. government would be borrowing more heavily to pay for this exemption. Both Harris and Trump are acting irresponsible given how much out-of-control government spending has caused the current fiscal state the U.S. finds itself in.
Conclusion. To recap, exempting tips from taxation has no clear rationale, has the potential to be highly distortive by adding complexity to the tax code, and could be abused by those looking for loopholes. Even if there are safeguards, it does not help out the vast majority of low- and middle-income workers. What could help? Raising the standard deduction would be a better approach that does not discriminate against sector or job type. Expensing for capital investment would also increase investment, which would boost worker productivity and wages. A balanced budget or a less complex tax code would do more wonders. If we care about sound tax policy, exempting tips from taxation is something we should avoid.
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