February 19, 2025
Trump’s Proposal for No Tax on Tips - A Closer Look
This is the fourth in a series of articles for clients to keep them updated on the thinking on Capitol Hill on proposed tax changes so you can plan appropriately. This delves into President Trump’s proposal to eliminate taxes on tips which he reiterated when attending a rally in Las Vegas on January 25, 2025.
Article Highlights:
- Trump’s No Tax on Tips Proposal
- Understanding the Proposal
- Potential Benefits
- Potential Drawbacks
- Economic and Social Implications
- Unanswered Question
- Federal Budgeting Considerations
A move that has sparked considerable discussion among both workers and economists is President Trump’s proposed policy to eliminate taxes on tips. This proposal aimed to provide financial relief to millions of service industry workers who rely heavily on tips as a significant portion of their income. Here, we delve into the potential impacts and implications of such a policy.
Understanding the Proposal: The proposal to eliminate taxes on tips is rooted in the desire to increase take-home pay for workers in the service industry, such as waitstaff, bartenders, and other tipped employees. Currently, tips are considered taxable income by the Internal Revenue Service (IRS), and employees are required to report them as part of their earnings. Trump's proposal, for which details are currently lacking, sought to change this by exempting tips from federal income tax. According to the Budget Lab at Yale University roughly 4 million individuals, or about 2.5% of all employees work in occupations that receive tips.
- Potential Benefits:
o Increased Take-Home Pay - The most immediate benefit of this proposal would be an increase in take-home pay for tipped workers. By not taxing tips, employees would retain a larger portion of their earnings, potentially improving their financial stability.
o Boost to the Economy - With more disposable income, service industry workers might spend more, potentially boosting the economy. This could lead to increased consumer spending in other sectors as well.
o Simplified Tax Reporting - Eliminating taxes on tips could simplify tax reporting for both employees and employers. Workers would no longer need to meticulously track and report their tips, reducing the administrative burden. - Potential Drawbacks:
o Revenue Loss for the Government - One of the significant concerns is the potential loss of tax revenue. Tips contribute a substantial amount to federal income tax collections, and eliminating this source could impact government funding for various programs.
o Equity Concerns - Critics argue that the proposal might disproportionately benefit higher earners within the service industry, such as those working in upscale establishments, while not addressing the broader issues of wage inequality.
o Compliance and Enforcement - There could be challenges in ensuring compliance with the new rules, as distinguishing between tips and other forms of income might become more complex. There’s also the issue of whether employees and businesses would want to move from full wages to a tip-based payment approach to avoid taxes. Potentially more service industries might follow the restaurant industry’s method of a specified price up front and an expected voluntary tip at the end of the transaction. Any legislation adopting the exclusion of tips from income will need to be carefully crafted to take into consideration potential loopholes and to prevent abuse.
o State Laws – Some states may not go along with the idea that tips should be excluded from tax, in which case simplified reporting suggested as a positive result of excluding tips from income will add back a layer of complexity. - Economic and Social Implications: The proposal to eliminate taxes on tips is part of a broader conversation about wage structures and income inequality in the United States. While it offers immediate financial relief to workers, it also raises questions about long-term economic impacts and the role of tips in the overall compensation system.
- Unanswered Question: The issue of whether Social Security taxes are included in the proposal by President Trump remains unclear although he has said it does. Generally, tips are subject to both income tax and FICA taxes, which include Social Security and Medicare taxes. If a policy were to exempt tips from taxation, it would be crucial to clarify whether this exemption applies to both income and FICA taxes. Currently the payroll taxes that fund Social Security and Medicare total 15.3% of a worker’s salary, of which half is paid by employers.
If tips were exempt from Social Security taxes, this could potentially impact the Social Security benefits of tipped employees. Social Security benefits are calculated based on an individual's earnings that are subject to Social Security taxes. Therefore, if tips were not subject to these taxes, it could result in lower reported earnings for Social Security purposes, potentially reducing the retirement benefits that tipped employees would qualify for.
The exclusion of tips from Social Security and Medicare taxes could impact more than just tipped employees. According to the Congressional Budget Office, Social Security’s trust fund will be depleted by 2035, resulting in a 23% cut to benefits for all SS recipients. If less money goes into the fund if payroll taxes on tips are excluded, the fund and Medicare could be depleted sooner, leaving millions of Americans without Social Security benefits for retirement. - Federal Budgeting Considerations: It is estimated that eliminating both the income and payroll tax on tips could reduce the federal revenue by as much as $250 billion over 10 years.
We will have wait and see how this plays out in Congress.
Stay Tuned.
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