Exempting tips from Taxes: A costly illusion

Former President Donald Trump's proposal to exempt tips from federal income and payroll taxes would exacerbate inequities and distort the tax system, while a broad-based tax system with low rates and minimal exemptions would create a more equitable and efficient tax system.

Former President Donald Trump’s proposal to exempt tips from federal income and payroll taxes might sound like a windfall for service workers, but it’s a costly illusion that undermines fair tax policy and economic efficiency. This plan, proposed as legislation by Sen. Ted Cruz (R-Texas), designed to appeal to a crucial voter base, exacerbates inequities and distorts the tax system. There’s a better way.

The core problem with exempting tips from taxes is that it narrows the tax base, leading to potential hikes in overall tax rates on tipped workers and everyone else to compensate for deficit spending. A broad tax base with low rates is essential for minimizing economic distortions and spreading the tax burden fairly. Narrowing the base by exempting tips would shift the burden to non-exempt income earners, creating an uneven playing field and violating sound tax policy.

This proposal picks tipped workers as winners over everyone else, incentivizing more tipped jobs and payments. Today, nearly every payment app prompts users for tips, a practice that could proliferate further under such a tax exemption. This disrupts consumer behavior and distorts the labor market by artificially boosting the attractiveness of tipped positions over other roles, regardless of the actual economic value they generate.

Moreover, this policy would discourage employers from raising the base wages of tipped employees. The federal minimum wage for tipped workers has stagnated at $2.13 per hour since 1991, and making tips tax-exempt might reduce the pressure to increase this base wage by employers, harming the workers it aims to help.

Fiscal implications are significant. Estimates suggest exempting tips could reduce federal revenue by $150 to $250 billion over a decade. This shortfall requires higher taxes on other income forms or cuts to public services. Additionally, the potential for increased tax avoidance, as employers and employees reclassify wages as tips, would complicate tax administration and enforcement.

A more effective approach would be to make the individual income tax cuts from the 2017 Tax Cuts and Jobs Act permanent, as they expire next year. Coupled with broadening the tax base and lowering rates, this would create a more efficient and equitable tax system. Reducing or eventually eliminating corporate income taxes could stimulate investment and economic growth, benefiting a broader range of Americans.

Milton Friedman, the renowned free-market economist, advocated for a broad-based tax system with low rates and minimal exemptions. His philosophy centered on minimizing government intervention and ensuring tax policies do not distort economic decisions. Focusing on permanent tax cuts and broader reforms can create a more robust and fair economic environment that truly benefits all workers.

Addressing excessive government spending, which has contributed significantly to our fiscal crisis, is also crucial and missing from Trump’s proposal. Neither Trump nor many Republicans seem to be advocating for significant spending cuts these days. Committing to reducing government expenditures would help manage the fiscal crisis and boost economic growth and prosperity by leaving more resources in the hands of individuals and businesses.

While Trump’s proposal might seem appealing, it fails to address deeper issues within the tax system and the labor market for service workers. A broad-based tax system with low rates and minimal exemptions and less government spending is a more equitable and efficient approach that would support more prosperity than exempting tips from federal taxes.

Vance Ginn, Ph.D., is the president of Ginn Economic Consulting, host of the “Let People Prosper Show,” and was previously the associate director for economic policy of the White House's Office of Management and Budget, 2019-20. Follow him on X at @VanceGinn.