Both Vice President Harris and former President Trump have recently endorsed the idea of exempting tipped income from federal income taxes. The effort also has a vehicle in Congress with a bill introduced by Senator Ted Cruz. If the federal tax code is changed, Maine lawmakers may also be asked to match the exemption on state income taxes. However, while it’s appealing to help tipped workers, many of whom survive on low incomes, exempting tips from income taxes is bad policy.
Here are three reasons why.
[1] To help workers with low income struggling to pay the bills, focusing on just tipped workers isn’t enough
According to the Yale budget lab, around a third of workers who earn tips live in households with no federal income tax liability. Exempting their tipped income from taxes won’t help them at all. Depending on how the policy is structured, it could even hurt some of these workers by reducing their eligibility for tax credits which depend on having taxable earnings.
Workers who rely on tips make up a very small share of the workforce — around 2% of all Maine workers are tipped workers, and while they are concentrated among the workers with the lowest wages, only 7% of workers in the bottom fifth of the workforce by wages (those earning less than $16.75 per hour) are in tipped occupations. There’s no reason to give a tax break to a waiter but not to the fast-food worker next door or the line cook out back.
[2] There are better ways to improve financial outcomes for tipped workers and families with low income
One reason tipped workers often struggle to make ends meet is that in most states, including Maine, employers are not obligated to pay the full minimum wage if they earn enough tips to get to the full minimum wage. In Maine, this tipped minimum wage is half the regular minimum, or $7.08 per hour in 2024. In states that follow the federal minimum wage, it’s just $2.13 per hour. In the seven states without a lower minimum wage for tipped workers, tipped workers earn more and have more predictable incomes. If lawmakers really want to help tipped workers, they should focus on raising the tipped minimum wage.
If either presidential candidate — or lawmakers in Washington, DC and Augusta — want to help workers with low incomes, there are much better tools available. In particular they should expand two tax credits for families with low income: the Earned Income Credit and the Child Tax Credit. These credits help move millions of working families out of poverty and could be increased to reach even more. Exempting tipped income from taxes is estimated to cost around $200 billion over a decade at the federal level, roughly the same as a proposal to make the Child Tax Credit fully refundable, which would benefit 16 million children and move 400,000 of them out of poverty.
[3] Exempting tips from income taxes may have unintended consequences
Economic analysts point out that creating a new class of income totally exempt from taxation could create incentives for more tax avoidance. Wealthy individuals would be motivated to find ways to convert their existing income into “tips” to get a new tax break. This could be particularly easy for professions that are already paid bonuses by their employers or customers, like hedge fund managers or lawyers.
We already have examples of wealthy individuals reclassifying their income type to avoid paying taxes. Hedge fund managers often take their compensation in the form of capital gains to pay a lower income tax rate. Owners of S-Corporations avoid paying tens of billions into the Medicare trust fund each year by reclassifying their personal income as corporate income. There’s a real risk that exempting tips from taxes creates a new loophole that can be similarly exploited.
Conclusion
If lawmakers want to help service workers who are struggling to get by, there are much better proposals available than exempting tipped income from taxation. Policymakers can address the needs of households with low income through targeted tax credits, and workers with low income by raising both the full and tipped minimum wage.
