Tax Tips

One part of the Big Bloated Bill is actually popular... and it's really dumb

The Big Bloated Bill getting signed into law today is pretty broadly unpopular—but there is one section that has garnered broad bipartisan support: a federal income tax deduction for tips. The idea polls so well that when Donald Trump floated the idea during the presidential campaign, Kamala Harris immediately jumped on the bandwagon. But while it’s not the worst—or indeed the 20th worst—thing in that bill, it’s also an terrible idea.

Let’s start with the obvious: This is temporary tax relief being arbitrarily directed to a tiny segment of the workforce—about 2.5% of workers, of whom 37% already pay no federal income tax—with no real coherent policy rationale behind it. Normally this sort of targeted tax deduction would be aimed at incentivizing behaviors we want to encourage for other policy reasons—like encouraging adoption of solar power or electric vehicles. There’s no such justification here: It’s just a massive tax break for certain essentially random categories of workers, which in the long run is going to need to be made up by either debt or taxes paid by other workers.

The New York Times did the math using two imaginary employees to illustrate how weird this is. If a retail clerk and a bartender both make exactly $40,000, and both take the standard deduction, but the bartender pulls a little over half of that total in tips, the clerk will have a federal income tax bill of $2,641, while the bartender owes $200. Nobody’s going to begrudge the bartender the break, but it hardly seems like an equitable or rational way to apportion tax liabilities.

Worse, it mucks with private markets in a variety of ways. For one, it distorts price signals: By effectively raising compensation for specific categories of employment, it’s sending a false signal indicating higher relative demand in those sectors. That’s undesirable because clear price signals are how markets allocate resources—including labor—to their best uses. A more subtle problem is the way it interacts with the increasingly prevalent policy of restaurants adding an automatic 20% gratuity or “service charge” to checks, which I find a little annoying personally (if it’s not optional, just increase the listed price by 20%!) but has the happy consequence of stabilizing workers’ incomes and reducing swingy vulnerability to a few cheapskate tables. Since the statutory text only applies to “voluntary” tips, that creates a massive incentive against a policy businesses are otherwise choosing. (If the exemption did apply to “tips” via mandatory service charges, of course, you’d have the opposite problem: A massive incentive to shift compensation into the exempt bucket.)

While there’s no good policy rationale here, there is an obvious political rationale: It’s a sop to a concentrated demographic, who legislators hope will be grateful for the break. Broader working and middle class tax relief would either blow a much bigger hole in federal revenues (which is apparently only acceptable when the recipients of the breaks are wealthy) or, if it did not, be too small for most workers to care much about or be appropriately grateful for.

But that makes it bad civics as well as bad economics. It creates a chunk of the workforce that now has little personal stake in tax policy beyond preserving their own targeted exemption. It would be unsurprising if many became single-issue voters on that question. And it signals to others that the most effective way to mobilize politically is by seeking similar sector-specific carve-outs rather than more universal tax reforms that would effect all similarly-situated workers in an evenhanded way. This is what the kids used to call “splitting the popular front.”

This is an instance of what public choice theorists call the “concentrated benefits, diffuse costs” problem. If you propose to throw a billion dollars worth of subsidy at Widget manufacturers, that’s a billion dollars worth of incentive for them to lobby for the subsidy, whether or not it makes any independent policy sense. Since the costs of the subsidy are diffused among all taxpayers, though, nobody has a remotely comparable incentive to organized against the subsidy: Even if it’s entirely wasteful and irrational, it’s not costing any individual taxpayer enough to get too worked up about. But, of course, when many such subsidies accumulate, it does end up costing everyone a significant amount.

The temporary tax exemption for tips is just an instance of the same dynamic on the tax side. It encourages us to think of tax policy through the lens of what special favors can be obtained for our own particular sector or faction, rather than what kind of revenue collection would be rational and equitable for workers as a whole.