Just over a week into his second presidency, Donald Trump is moving at breakneck speed, signing executive orders and implementing ambitious policy reversals that could have transformative effects. Amid this blizzard of activity, some of his narrower, more specific proposals might be overlooked. One that gained significant attention during the campaign was his pledge to do away with taxes on tip income. 

If Republicans want to pursue this policy, they’ll need to answer some questions about what Trump’s promise means. And they’ll need to be careful that the idea doesn’t turn into a budget-buster.

Several key considerations will dictate the cost of not taxing tips. Does “no tax on tips” mean no income taxes, or no income taxes and no payroll taxes? It also matters whether the untaxed tips represent all income classified as tips, or just tips earned in specific service industries that historically rely on tips, like food services or hospitality.

The effects of these decisions add up. The Tax Foundation estimates that exempting tips from the income tax would cost $118 billion in revenue over the next decade. Including exemptions from both the income and payroll tax would end up costing closer to $200 billion. The Yale Budget Lab estimates an income-tax-only exemption targeted at just leisure and hospitality industries would cost $62 billion.  

These projections come with significant uncertainty, though, because of how a tax change would affect behavior. If one type of income (salaries) is taxed, and another type (tips) is not, people will prefer to be paid in tips rather than in salary. We would then expect people to shift their compensation from wages and salaries to tips to take advantage of this difference. That would lead to a significant increase in (untaxed) tipped income, a decline in (taxed) wage and salary income—and a larger decline in tax revenue.

The Tax Foundation includes a 10 percent increase in tipped income in our estimate to reflect this potential. But tips are complicated. Unlike tax-exempt fringe benefits, where employees have some discretion over how much compensation they receive, tips are entirely at customers’ discretion. Removing the tax on tips would make receiving more of your income in tips more beneficial, but we lack historical examples that show how tipping behavior would change in response.

Tips have a clear definition for tax purposes: the payment must be made “free of compulsion,” and the customer determines the amount—it cannot be the result of negotiation. Those restrictions make it illegal to misclassify ordinary wage and salary income as tips.

But this asterisk has its own asterisk. A more complex tax code means more administration and enforcement challenges. Though misclassifying tipped income is illegal, and big earners suddenly classifying all their income as tips would raise alarm bells, the IRS is not all-seeing (contrary to popular image). A hole in the tax base like “no tax on tips” is an invitation to tax evasion. Clear guardrails would be needed to discourage misclassification.

The macroeconomic effect of exempting tips from income taxes would be limited. But it could distort the labor market, encouraging more people to enter traditionally tipped jobs like food service and hospitality and avoid untipped fields.

That change could undermine conservatives’ efforts to build up the American industrial base. Last year, an advertisement for jobs in submarine manufacturing depicted a woman dressed as Rosie the Riveter struggling at a handful of service-industry jobs, like driving for a rideshare service and delivering food, before finding satisfaction as a shipyard technician. Without a tax on tips, a significant portion of “Rosie’s” income from delivering food would be tax-exempt, while her salary as a submarine tech would be taxed in full. Why?

“Why” is the relevant question for advocates of “no tax on tips.” There is no strong policy justification for excluding tipped income from the income tax. If the goal is to help lower-income workers, broader tax reductions would be a better solution.

“No tax on tips” is not a particularly large policy when compared with making the whole Tax Cuts and Jobs Act permanent (price tag: $3.6 trillion to $4.3 trillion). But the budget process will include lots of haggling over policy changes that, on their own, cost much less than $100 billion over ten years. Republicans already must find ways to pay for structural improvements to the TCJA, such as a higher standard deduction, a larger child tax credit, and lower individual rates. Including “no tax on tips” in a budget package will make that challenge about $100 billion harder.

Photo by Gary Hershorn/Getty Images

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