Donald Trump, our once and possibly future president, has been speaking about his idea to eliminate taxes on tips. He got the idea from a very intelligent waitress in a restaurant in one of the Trump buildings.
The idea is part of the Republican Party platform for 2024, which states:
“Republicans will make permanent the provisions of the Trump Tax Cuts and Jobs Act that doubled the standard deduction, expanded the Child Tax Credit, and spurred Economic Growth for all Americans. We will eliminate Taxes on Tips for millions of Restaurant and Hospitality Workers, and pursue additional Tax Cuts.”
Of course the platform statement does not get into the nitty gritty details. There are two proposed bills to amend the Internal Revenue Code to make tips more or less tax free. There is the “No Tax on Tips Act,” the Senate bill introduced by Ted Cruz (R-Texas) and the “Tax Free Tips Act of 2024,” the House bill by Thomas Massie (R-Ky) and Matt Gaetz (R-Fla.).
Two Bills
As I read them, the two bills would have profoundly different results.
Consider a hypothetical restaurant server who is among the group of workers who don’t make a lot more than minimum wage. The server is a single parent with three kids and she gets by in part because of the child support that her ex-husband irregularly provides. In 2023, she worked 2,000 hours for $4,260 in wages and $30,000 in tips, which works out to $17.13 per hour. There is $2,621 in Social Security and Medicare tax withheld from her pay. Her employer has to match that, but a credit is given to the employer to the extent of the match that is above the minimum wage.
Then we come to income tax. The server’s income tax of $1,348 on line 16 of Form 1040 is reduced to $0 by the child tax credit. But that’s not all. There is the earned income tax credit of $1,963 and the additional child tax credit of $4,652 resulting in a refund of $6,615. So on net considering the withholding for Social Security and Medicare tax and the refund on Form 1040, IRS is paying the server $3,994.
The Senate Bill creates an above-the-line income tax deduction for cash tips reported to the employer. This will be a significant benefit to higher earners or those without dependents, but it will not change the server’s bottom line at all.
The House Bill is different. It amends Section 102 to define tips as gifts. It eliminates Social Security and Medicare tax on tips and unemployment tax. It is a great deal for the server’s employer, but kind of disastrous for the server. She would save $2,295 in Social Security and Medicare tax, but her 1040 refund is reduced by $4,897 because earned income is so much lower. The saving in Social Security and Medicare tax is not a pure saving as it may have an effect on future benefits. For people with very low lifetime earnings (average indexed monthly earnings below $1,174), the return on additional amounts paid into Social Security is actually quite good.
It is worth noting that both bills and all the rules currently existing apply to tips to employees. There are a lot of people who receive tips who are not employees. Among them are many of the entertainers in “gentlemen’s clubs” and meal delivery drivers. Nether of the bills apply to them.
Is The Server’s Scenario The Norm?
There seems to be a lot of information on how much tipped employees make. Some of it must be true, but I am not able to discern what. This report titled “Short Changed” states:
“While the national median individual income in the United States is $40,480, tipped restaurant workers median individual income is just 37 percent of the national median income, at only $15,198. High earning tipped restaurant workers are nearly nonexistent, and over 95 percent of these workers earn less than $53,000 a year.”
A former waiter whom I consulted encouraged me to go to Reddit for some information. The discussion under “How much do servers make in tips?” provides anecdotal evidence that things might not be quite so grim for tipped employees. There are comments like:
“I once took a promotion to salaried management at $55k/year and it was a pay cut for more hours. I wouldn’t wait tables for $23k a year unless it was 2 shifts a week maximum.”
Regardless, the argument in favor of the no tax on tips proposal seems pretty weak. Proposed legislation does little or nothing for or actually harms low-paid servers. And when it comes to higher-earning servers I have a hard time seeing why someone who makes $80,000 per year serving in a high-end restaurant, assuming they are not nonexistent, should be exempt from income tax on most of their income as opposed to people in all sorts of other disparate jobs earning that sort of money. Of course I feel the same way about clergy having exempt housing allowances in the hundreds of thousands.
About The EITC
The idea that an income exclusion can end up hurting someone is counter-intuitive, but it is a real thing. An exemption that nobody I know of objects to is Section 112 – Certain combat zone compensation of members of the Armed Forces. Without digging too far into the fine points all or most of the compensation that service members earn in any month in which they serve in a combat zone or are in hospital as a result of wounds, injury or disease as a result of service in the combat zone is excluded from gross income. The exclusion for officers is limited to what the highest paid enlisted member earns, which is more than what most officers make.
It seems like it came as a bit of a shock in the early stages of the War On Terror, when junior enlisted service members found they came out behind when they were deployed. That was because they had qualified for the earned income credit, but when they qualified for the combat pay exclusion, they no longer had earned income. The 2004 Working Families Tax Relief Act added an election that allows combat pay to be included in the earned income computation. The 2008 Heroes Earnings Assistance and Relief Act made the election permanent.
Warren Buffett is a great proponent of the earned income tax credit as an antidote to the extreme inequality that a successful free market economy is bound to create.
I frequently do an “Other Coverage” section on my posts, but I wouldn’t know where to start on this topic. I will note though that I have not found another article where somebody ran numbers on the effect of the various legislative proposals. Reilly’s Sixth Law of Tax Planning is Don’t Do The Math In Your Head.
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