In a seemingly rare moment of bipartisan unity, Vice President Kamala Harris joined her opponent in the 2024 presidential election, former President Donald Trump, in proposing that income from tips and gratuities of service and restaurant employees should be exempt from federal taxes.

While little has been done to legislate on this, the mere fact that both presidential candidates are proposing a similar change suggests that a world of tax-free tips may be on the horizon. Here’s how tips are currently taxed and what that world of tax-free tips might look like.

Tax tips

Here’s how Section 61 of the Internal Revenue Code defines it: “Except as otherwise provided in this subtitle, gross income means all income from any source.” This includes everything from your regular paycheck to investments to winnings from sports betting – even $20 you find on the sidewalk. Any income that meets this definition should appear on your federal tax records, and you should pay taxes on all of that income.

This broad definition includes tips. Tips are commonly earned in industries such as food and beverage and entertainment. In the United States, restaurant patrons typically add 20% to the price of the meal to compensate the waiter and his team for their efforts. In a casino, it is customary to tip the dealer. Whether these tips are paid in cash or electronically, the Internal Revenue Code defines the money received as income and requires the recipient to report it and pay taxes on it.

Although tips are taxable, they are often a means of tax evasion. For example, if you tip a waiter in cash or give money to a valet after returning your vehicle, there is little to no record of that transaction. The person may simply pocket the money without reporting the income on their tax return, thus avoiding paying taxes.

The benefits of deducting tip tax

It is not uncommon for tax cuts to be proposed in an election year. Politicians are accused of using them to increase their electoral chances.

Whether they affect elections or not, tax cuts always create winners and losers. And the winners of Harris and Trump’s proposals are the service industries. Many people in these jobs earn less. According to ZipRecruiter, the average salary for a restaurant waiter in North Carolina is $23,971. Even professional waiters who work in more upscale establishments only earn between $54,000 and $97,000.

Tax cuts for these low- and middle-income earners will increase their purchasing power. Such policies could be especially important in an election year when swing states like Arizona and Nevada (both with very large service sectors) could determine the outcome of the election.

Small business owners in these industries would also benefit from a tax exemption on tips. It is the employer’s responsibility to collect tips from employees and include them in regular (usually monthly or quarterly) payroll reports. Employers must also track all tips their employees give throughout the year and include the total amount on employees’ annual W2 reports.

It’s worth noting that neither Harris nor Trump have made clear which taxes they would exempt tips from. We’ve addressed payroll taxes here, but employees and employers are also each subject to Social Security and Medicare taxes, which total 7.65 percent of tip income. If tips end up being completely “tax-free,” that means both employees and employers potentially save on payroll taxes.

Implementing this change in tax law would be relatively easy. In the United States, different types of income are often taxed differently. For example, people who sell stocks at a higher price than they bought them for must report the difference as income. These capital gains are taxed at a lower rate than other types of income. The same is true for dividends from owning stock in a company. In addition, income from interest on municipal bonds is tax-free – similar to the proposed treatment of tips.

Possible disadvantages of tax exemption on tips

Economic fundamentals suggest that such a change will have unintended consequences. A tax-free tip policy, for example, could encourage employers to cut wages or slow wage increases until a new equilibrium is reached by increasing workers’ effective income (through a tax cut). Another economic concern would be that increasing the purchasing power of a large group of people could drive up inflation, similar to how the economic stimulus during the COVID-19 pandemic fueled inflation in the early 2020s.

While the law is relatively easy to implement, the potential for loopholes and exploitation may be insurmountable. For example, consider a self-employed individual who owns a business that receives payments for services from customers. Before the tip tax was eliminated, he paid himself an annual salary of $1 million from a small, sole proprietorship. After tips become tax-free, he might try to reclassify his income as a salary of $100,000 and tax-free tips of $900,000.

That’s an extreme example, but consider another one from an industry where wages and other income are more often mixed. A barber often charges a standard fee for a haircut and also accepts tips. There would be no way to prevent him from changing his payment structure and classifying all compensation as tips.

Policymakers will need to be very careful to prevent loopholes from being exploited. This careful wording will likely include defining the sectors affected and limiting the tax-free amount.

Another potentially significant, unforeseen disadvantage for workers is the potential impact on their Social Security payments if tips become completely “tax-free.” Many service industry workers receive a significant portion of their income in the form of tips. Currently, all of the income they report goes into the pool of qualifying earnings, which ultimately determines how much they receive in Social Security payments after retirement. The amount of Social Security retirement benefits is based on the highest 35 years of past earnings.

For a college student who works part-time as a waiter, this may not be a big deal. But for older workers or full-time employees, cutting tips from Social Security can significantly reduce their retirement benefits.

Given the candidates’ lack of clarity about the taxes they would exempt tips from, it is not clear how tips will be treated for Social Security purposes. If lawmakers ultimately make tips tax-free for federal income tax purposes, they will need to think carefully about whether to also exempt them from payroll taxes and thus exclude them from “paid-in” Social Security benefits.

The biggest downside to a tax-free tip plan might be that it has a relatively small impact on employees. Consider the waiter in North Carolina who makes $23,971 per year after the standard deduction ($14,600 in 2024): He’ll pay just $937 in federal income taxes in 2024. Assuming all of his income comes from tips, the most he’d save in federal taxes would be $937. If he also foregoes payroll taxes, he’d save another $1,834. Most likely, that waiter would also have non-tip income, so the tax savings would be even smaller.

While this extra money would be a welcome change for many, recent increases in the costs of housing, transportation, and basic goods and services seem to dwarf its value, especially in light of the other disadvantages of tax-free tips.

Considerations for the future

Policymakers want to put forward simple proposals that would improve economic conditions for lower- and middle-class taxpayers. Exempting tips from tax is one promising possibility, but there are other economic levers they can consider. For example, raising the minimum wage or increasing tax credits for low-income taxpayers could be similarly effective. While each of these options has its own drawbacks, they are certainly avenues that can and should be considered.