Tip Exemptions Have No Place in State Income Tax

Creating a special tax break for tipped income – as at least 20 states are considering this spring – would harm state budgets, encourage tax avoidance, and fail to reach the vast majority of low- and middle-income workers. In fact, a devastating analysis by the Economic Policy Institute (EPI) explains that tip exemptions will hurt more workers than they help.

The benefits of a tip exemption would be extremely narrow. Surprisingly few U.S. workers, even those with low incomes, rely on tips to make ends meet. About one in 40 U.S. workers – and only one in 20 low-wage workers – receives any tips at all. For those who do, tips are usually just a small share of their earnings. To make matters worse, the change would fail to benefit many low-income tipped workers because their incomes are too low to have an income tax liability to begin with.

A tip exemption would also create new avenues for tax avoidance. Income taxes are generally fairest and easiest to administer when they treat all types of income the same. There’s no good reason for the tax system to favor a worker who delivers food (and receives tips) over a worker who delivers packages and gets no tips. Nor should it favor a worker who gets tips for cutting hair over a worker who gets no tips for cutting drywall.

Not only is tax favoritism inequitable, but it could encourage employers to reclassify wage income as tips or even figure out ways to push consumers to tip more and then still cut wages equivalently. That means workers would see their weekly incomes become less stable and predictable, while consumers would face even more tip requests. And the spread of tip requests might not stop at food-service workers; a tax incentive could encourage high-earning accountants, lawyers, and financiers to include an expectation of “tips” in their pay structures.

Even without increased tax avoidance, the cost to state budgets of these proposals would be substantial. Arizona, for example, estimates the loss of revenue from a tip exemption at $31 million a year and acknowledges that income reclassification could drive the cost higher – funds that would come at the expense of schools, health care, and other public services workers count on. This would add to fiscal pressures that states face due to declining revenue, weaker IRS enforcement of tax collections, federal layoffs, and other factors.

The good news is that states already have tried-and-true strategies to help both tipped and non-tipped workers make ends meet. Even if Congress decides, unwisely, to exempt tips from federal income tax, states can decline to conform with the federal change. Instead, states can raise their minimum wages, enact or expand refundable tax credits like the Earned Income Tax Credit or Child Tax Credit, flip the upside-down nature of most state tax systems, or make it easier for workers to form and join unions to push for better pay. These alternatives to a tip exemption would help workers, not hurt them.

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