Exempting Tips from Taxes: The Risks and Realities

⏱️ 11 min read                

Today we’re tackling a topic that hits close to home for millions of workers — tipping. Has tipping reached its limit, or are we just getting started? Both major presidential candidates have a surprising proposal: exempting tips from taxes. Sounds great, right? 

But here’s the catch — it could encourage even more reliance on tipping and leave workers more vulnerable than ever before. Are we on the brink of a tipping revolution, or is this just a recipe for disaster? What are the hidden consequences of this new tipping debate? 

Welcome to That's Life, I Swear.  This podcast is about life's happenings in this world that conjure up such words as intriguing, frightening, life-changing, inspiring, and more. I'm Rick Barron your host. 

That said, here's the rest of this story  

Americans are now being asked to tip in more situations and locations than ever before, from fast food counters and corner stores to auto repair shops, car washes, and even self-checkout stations. This trend has frustrated many customers and sparked disagreements between employers and tipped employees.

Leaving a tip at the table. Courtesy of Thoughtful reading

And it may only intensify. Both major-party presidential candidates have recently supported proposals to eliminate income taxes on tips, effectively subsidizing tipping and encouraging more businesses to adopt it as a standard practice.

Economists across the political spectrum have criticized the idea, arguing that it is unfair — giving an advantage to some low-wage workers over others — and could have unintended consequences. Even some tipped employees and organizations representing them are doubtful and concerned that the policy could reduce pay over time.

Yet the debate highlights how service-sector workers emerged from the pandemic as a significant economic and political force. The recent rise in tipping was partly driven by the high demand for workers and the bargaining power it provided them. The competing proposals from the presidential candidates show that they view the nation's approximately four million tipped workers as an essential group to win over.

One side of the population doesn’t favor the tax exemption idea, but see an increased focus on the issue that might lead to more crucial policies. Among them is eliminating the subminimum wage, which permits businesses in some states to pay workers as little as $2.13 an hour, provided their tips bring their total earnings up to the full minimum wage.

Aaaah, $2.13 cents. Really!? I mean who makes up these stupid policies!? 

However, it's uncertain whether the rapid changes in the tipping landscape will ultimately benefit employees. Already, some workers report a decline in their tips as more customers grow weary of constant tipping requests — a trend that is supported by some data. There's also evidence that certain businesses are using tipping as a way to sidestep larger wage increases. Both of these trends could worsen if the economy takes a downturn.

As tipping becomes more common in industries where it was previously rare, more workers could suffer if customers start cutting back.

“The more your wages depend on tips, the more precarious your livelihood becomes,” said Amanda Cohen, a chef and restaurant owner in New York City who opposes tip-based compensation. “And I’m not sure why we would push more people into that system.”

A Shift Sparked by the Pandemic

A decade ago, Amanda Cohen was at the forefront of a different movement regarding tipping: getting rid of it altogether.

In 2015, Ms. Cohen eliminated gratuities at her vegetarian restaurant, Dirt Candy, opting to raise wages across the board for all employees—whether servers or line cooks—while increasing menu prices to cover the costs. This approach caught on with some restaurateurs, including Danny Meyer, who owns well-known New York spots like Gramercy Tavern and Union Square Cafe.

Ms. Cohen, Mr. Meyer, and others who embraced this model argued that tipping was flawed for several reasons:

1.     It created financial uncertainty, as servers could never predict their earnings from one shift to the next. 

2.     It also led to inequities; tipped workers often earned significantly more than line cooks who were paid hourly at upscale establishments like theirs. 

3.     Additionally, tipping opened the door to racial bias, sexual harassment, and other forms of discrimination and abuse.

However, the movement to eliminate tipping failed to gain widespread adoption beyond a small number of high-end restaurants in major cities. Whatever momentum it had was largely derailed by the pandemic.

Early in the pandemic, many Americans showed their appreciation for in-person service workers by tipping generously, even in situations where it was uncommon, such as takeout orders. However, as restaurants and other businesses reopened, they faced an acute labor shortage. Establishments that did not allow tipping found it challenging to retain staff, losing employees to competitors that permitted tipping.

Danny Meyer stated "By the summer after the pandemic began, we realized we couldn’t attract any workers without allowing tips." His restaurants abandoned their no-tipping policy in July 2020. 

Economists have found it challenging to pinpoint precisely how much and where tipping has expanded. Agencies like the Bureau of Labor Statistics and the Census Bureau don’t collect or publish data about tipping in most surveys. While the Internal Revenue Service does release some data, it comes years later and excludes unreported tips.

However, data from private sources suggests that tipping has spread significantly. According to the payroll processing company Gusto, about half of all bakeries and ice cream shops now pay tips to their employees, a notable increase from roughly one-third before the pandemic. Tipping has also become more common in coffee shops, quick-service restaurants, and similar establishments where it was previously less frequent. 

On social media and online forums, customers often share more surprising examples, such as tip requests appearing at places like movie theater concession stands, airport newsstands, and even doctors’ offices. Gusto's data indicates that while these instances are still relatively rare, they are on the rise; the percentage of retail businesses accepting tips has nearly doubled since 2019, reaching around 6.5 percent.

The widespread use of technology has contributed to this trend: Tablet-based payment systems like Square and Toast make it easy for businesses to request tips.

For many businesses that have added tip screens, the decision has been driven by a fundamental economic need: they had to increase wages to retain employees but couldn’t afford to do so by raising prices across the board.

The Impact of 'Tip Fatigue'

For customers, the constant prompts to leave a tip — each requiring either compliance or a potentially awkward public refusal — can be draining.

Add a Tip screen. Courtesy of Men's Health

“It’s like asking yourself, ‘How generous am I feeling today?’ repeatedly,” she explained. “It’s an uncomfortable question to face five times a day.”

Many Americans express frustration with frequent tipping requests in surveys, with some indicating they are becoming less willing to tip. However, there is limited evidence to show this shift is actually happening. Data from Toast and other sources indicate that tipping has declined from its mid-pandemic peak but has recently stabilized.

Concerns over "tip fatigue" highlight the complex effects of tipping’s growth for workers. On one hand, tips have provided an essential boost to income during rising expenses and, so far, have been in addition to wage increases rather than a replacement for them.

On the other hand, workers are now more reliant on tips than ever. For instance, according to Square's data, gratuities currently make up about 20 percent of earnings for employees at quick-service restaurants, compared to around 10 percent before the pandemic. This dependency makes workers more vulnerable if customers start tipping less due to frustration or an economic downturn.

Working for tips can be a mixed blessing, as some days are great, but others aren’t so good.

The Debate Over Taxing Tips

This summer, former President Donald J. Trump aimed to resonate with workers like Ms. Mercer by proposing that tips be exempt from federal taxes—a conversation inspired an idea he said with a waitress in Las Vegas. In August, Vice President Kamala Harris also endorsed a similar proposal during a speech in Las Vegas, but unlike Mr. Trump, she combined it with a promise to raise the minimum wage.

Debating economics. Courtesy of SD City Times

The idea of tax-free tips quickly garnered support from the Culinary Workers Union in Nevada and industry groups like the National Restaurant Association.

However, economists argue that the proposals would disproportionately benefit higher-earning servers—some of whom make six-figure incomes primarily from tips—while providing no advantage to low-wage kitchen workers or employees in other sectors. Many tipped workers, like Ms. Mercer, wouldn't gain from the change either, since they earn too little to owe federal income taxes in the first place. While tips have been historically underreported on tax returns, experts suggest this is less common today than in the past, as more tips are now tracked electronically rather than paid in cash.

The proposals could also have a less obvious impact: encouraging more tipping. If tips are not taxed, workers might be more inclined to accept lower wages in exchange for higher tips. Over time, this could lead more businesses to adopt tipping practices for a wider range of employees.

This proposal shifts part of the compensation burden from wages to tips. This shift would benefit restaurants by lowering their costs, but for workers, it could mean earning a bit less in wages.

What can we learn from this story? What's the takeaway 

Proposals to eliminate federal taxes on tips present potential pros and cons. While the idea promises increased earnings for service workers, it also presents challenges involving revenue loss and ensuring those who need tax relief the most actually get it.

Evaluating these factors is crucial in deciding on tax exemptions for tips, given their broad implications for workers, businesses, and the economy.

Well, there you go, my friends; that's life, I swear

For further information regarding the material covered in this episode, I invite you to visit my website, which you can find on Apple Podcasts/iTunes, for show notes and the episode transcript.

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