The case for no-tax on tips

In the bustling restaurants of Brooklyn, the coffee shops of San Francisco, and the diners scattered throughout America’s heartland, there is an unspoken understanding: tips are more than mere wages — they are personal gestures of appreciation. Yet, the IRS treats these voluntary tokens of gratitude like standard income, subjecting them to taxation.

This long-standing system unfairly burdens service workers, who predominantly belong to lower income brackets. Tips are voluntary gifts, fundamentally different from earned wages. Reforming this policy isn’t just practical; it’s morally necessary. Eliminating taxes on tips would directly benefit workers, businesses, and even the wider economy.

The tradition of tipping in America dates back to the 19th century when wealthy travelers imported it from Europe for special treatment in hotels and restaurants. Ironically, the practice initially faced criticism as undemocratic, yet it eventually became ingrained in American culture. The Fair Labor Standards Act (FLSA) of 1938 formalized tipping by allowing employers to count tips toward the minimum wage and establishing the tip credit system.

Today, the IRS requires tipped workers to meticulously track and report every gratuity they receive, creating significant administrative burdens. Attempts at reform — like the proposed “Tipped Workers Protection Act” in 2017 — have aimed to address these inequitable barriers but have ultimately failed.

Tipping regulations vary greatly from state to state. In California, workers are paid a full minimum wage in addition to their tips, while in states like Texas and Georgia, employers increasingly rely on tip credits to meet minimum wage requirements. Internationally, the United States stands out as one of the few developed nations that imposes strict taxes on tips. In Europe, tips are often either untaxed or lightly regulated, reflecting an understanding of their voluntary nature. Moreover, advancements in digital payments — such as Venmo and Square — have made tip reporting simpler, creating both conveniences and challenges for workers and tax authorities alike.

The average tipped employee earns slightly above minimum wage, with tips making up about 58% of their take-home pay, according to the Economic Policy Institute. Take Maria, a waitress at a midtown diner in Manhattan, who told NPR last year, “I earn around $700 weekly in tips, but after taxes, it’s closer to $500. That $200 difference is significant when living paycheck to paycheck.” For workers like Maria, eliminating the tax on tips could be transformative, providing essential financial relief.

The economic rationale for tax-free tips goes beyond individual relief. According to a 2023 Brookings Institution report, lower-income individuals spend around 97% of any additional disposable income, creating a significant multiplier effect. A few extra hundred dollars each month can lead to increased spending at local businesses, which may elevate overall economic activity and have a positive effect on GDP.

Legally and philosophically, gratuities differ significantly from standard wages. Tips are voluntary transfers meant as expressions of appreciation, not mandatory payments from employers. Legal scholars emphasize that the IRS’s treatment of tips contrasts sharply with its tax-free approach to similar monetary gifts under $17,000 per year. Treating gratuities as taxable income thus contradicts broader gift taxation precedents and misrepresents customer intentions.

Taxing gratuities effectively imposes double taxation on service employees whose base wages already face standard payroll deductions. Additionally, tipping culture predominantly impacts lower-income workers; studies from Pew Research demonstrate how taxing tips exacerbate income inequality, disproportionately affecting the most financially vulnerable.

Tax-free tips result in higher net incomes, increased financial stability, and greater job satisfaction. Workers in hospitality and food services — industries known for high turnover — would likely see improved retention and career stability longevity.

The benefits for businesses are equally compelling. Reducing tax-related compliance could dramatically enhance recruitment and retention capabilities. It would also diminish the administrative burdens related to tracking and reporting tips, which currently cost businesses significant hours and resources. Employer testimonials collected by the National Restaurant Association suggest that reducing tax-related compliance would substantially diminish these burdens.

Customers, recognizing that their gratuities directly benefit workers without government interference, might feel incentivized to tip more generously. Enhanced transparency fosters trust between customers and servers, enriching the customer experience and bolstering consumer confidence in service industries.

Effective policy reform would require clear legislative guidelines, including a transition period and well-defined enforcement protocols. Payroll systems would need updates, though these would be significantly less burdensome than the current tax-reporting practices. Additionally, educating employees about their rights and responsibilities within this new system would be paramount.

Critics frequently cite lost tax revenue as a major barrier. However, economic studies such as those by the Congressional Budget Office indicate that any potential shortfall would likely be balanced out by increased consumer spending and economic growth driven by higher disposable income for workers. Alternative revenue sources — such as slight adjustments to corporate taxes or luxury goods taxes — could easily alleviate fiscal concerns.

The widespread use of digital payments and effective tip-reporting technologies will significantly decrease concerns about tax evasion. Technological solutions could enhance industry self-regulation, improving transparency and reporting accuracy.

Concerns regarding inflation or market distortions are unfounded. Labor market studies, particularly from MIT’s Department of Economics, suggest minimal effects on inflation or industry competitiveness due to the small scale of incremental disposable income changes and the spending habits of tipped workers.

Implementing a phased statutory change, starting with federal legislation explicitly exempting tips from taxable income, is advisable. Businesses should adopt standardized tip-tracking technology and comprehensive education programs for workers. Enforcement protocols must be clearly defined, practical, and minimally intrusive.

The economic and ethical reasons for making tips tax-free are persuasive and rooted in both practicality and fairness. Workers like Maria deserve equitable compensation for their labor, unencumbered by the undue burdens of tip taxation. Policymakers must acknowledge this necessity and act swiftly to implement meaningful reform. A tax-free gratuity system benefits not only tipped employees but also businesses, customers, and the overall economy. Now is the moment to make tipping truly equitable.