No tip tax – be careful what you wish for

Donald Trump, our former and possibly future president, has been talking about his idea of ​​eliminating tip taxes. He got the idea from a very intelligent waitress at a restaurant in one of Trump’s buildings.

This idea is part of the Republican Party’s 2024 platform.

“Republicans will make permanent the Trump Tax Cuts and Jobs Act, which doubled the standard deduction, expanded the Child Tax Credit and boosted economic growth for all Americans. We will eliminate tip taxes for millions of restaurant and hospitality workers and pursue additional tax cuts.”

Of course, the platform’s statement doesn’t go into detail. There are two proposed bills that would change the Internal Revenue Code to make tips more or less tax-free: the No Tax on Tips Act introduced in the Senate by Ted Cruz (Senate bill) and the Tax Free Tips Act of 2024 introduced by Thomas Massie and Matt Gaetz in the House of Representatives (House bill).

Two bills

As I read them, the two bills would have fundamentally different effects.

For illustrative purposes, I’ve made up a waiter at a restaurant. His name is Robin Waitstaff, and he’s one of a group of waiters who don’t make much more than minimum wage. Robin is a single parent of three children. They get by partly on the child support their ex Terry provides irregularly. In 2023, Robin worked 2,000 hours for $4,260 in wages and $30,000 in tips, or $17.13 an hour. Their wages have Social Security Medicare tax withheld from them in the amount of $2,621. The employer has to match this, but the employer gets a credit for the match that exceeds minimum wage.

Next, we move on to income taxes. Robin’s income tax of $1,348 on line 16 of Form 1040 is reduced to zero by the Child Tax Credit. But that’s not all. There’s an Earned Income Credit of $1,963 and an additional Child Tax Credit of $4,652, for a “refund: $6,615.” So net of the Medicare withholding and the refund on Form 1040, the IRS pays Robin $3,994.

The Senate bill creates an above-the-line income tax deduction for cash tips reported to employers. That will be a significant benefit to higher-income earners or those without dependents, but it won’t change Robin’s bottom line at all.

The House bill is different. It amends Section 102 to define tips as gifts. It eliminates the Medicare Social Security tip tax and unemployment tax. This is a great deal for Robin’s employer, but a disaster for her. They save $2,295 in Medicare Social Security taxes, but their 1040 “refund” is reduced by $4,897 because their earned income is so much lower. The Medicare Social Security savings are not pure savings because they can affect future benefits. For people with very low lifetime earnings (average indexed monthly earnings below $1,174), the return on the extra money they pay into Social Security is actually quite good.

It is worth noting that both bills and all currently applicable regulations concern tips. employees. There are many people who receive tips and are not employees. Among them are many entertainers in “gentlemen’s clubs” and food delivery drivers. None of the bills apply to them.

Is Robin the norm?

There seems to be a lot of information out there about how much tipped workers make. Some of it must be true, but I can’t tell what. A report titled Short Changed states:

“While the national median income for individuals in the United States is $40,480, the median income for tipped restaurant workers is just 37 percent of the national median income of just $15,198.9,10 High-earning tipped restaurant workers are almost nonexistent, with more than 95 percent earning less than $53,000 per year.”

A former waiter I consulted with encouraged me to visit Reddit for information. The discussion “How much do waiters make in tips?” provides anecdotal evidence that things may not be so bleak for tipped workers. There are comments like:

“I once got promoted to a management position at $55,000 a year, and it was a pay cut for more hours. I wouldn’t wait tables for $23,000 a year unless it was two shifts a week max.”

Regardless, the case for the proposal seems pretty weak. The proposed legislation does little or nothing for low-paid waiters or actually harms them. And as for waiters earning more, I have a hard time understanding why someone who makes $80,000 a year serving in a fancy restaurant, assuming that doesn’t exist, should be exempt from income tax on most of their income, as opposed to people in a variety of professions who make that kind of money. Of course, I feel the same way about tax-free housing allowances for clergy in the hundreds of thousands.

About the credit for income from work

The idea that an income exclusion could hurt someone is counterintuitive, but it is real. The exception that no one I know objects to is Section 112 – Certain compensation payments to members of the Armed Forces for service in war zones. Without going into too much detail, all or most of the pay that soldiers receive during any month that they serve in a combat zone or are hospitalized for wounds, injuries, or illness resulting from service in a combat zone is excluded from gross income. The exclusion for officers is limited to what the highest-paid enlisted man earns, which is more than most officers.

It seems to have come as a bit of a shock early on in the war on terror, when junior enlisted soldiers found themselves left behind when they were deployed. That was because they qualified for the earned income allowance, but when they qualified for the exclusion from the combat allowance, they no longer had earned income. The Working Families Act 2004 added an election that allowed the combat allowance to be counted as earned income. The Heroes Act 2008 made the election permanent.

Warren Buffett is a big proponent of the earned income tax credit as an antidote to the extreme inequality that inevitably arises from a well-functioning free-market economy.

I often include an “Other Coverage” section in my posts, but I don’t know where to begin on this topic. However, I notice that I haven’t found another article where someone calculates the effects of various legislative proposals. Reilly’s Sixth Law of Tax Planning – Don’t do the math in your head.