Sen. Ted Cruz’s No Tax on Tips Act Does Little for Low- and Moderate-Wage Workers But Opens Door to Tax Abuse by Wealthy

Sen. Ted Cruz (R-TX) and Rep. Byron Donalds (R-FL) recently introduced legislation dubbed the “No Tax on Tips Act,” which would exempt tips workers receive from income taxes. This could play a key role in tax legislation next year.

Yet the recent enthusiasm among backers of the Tax Cuts and Jobs Act of 2017 for exempting tips from income taxes is, perhaps, an implicit admission that they need tax policy that is more pro-worker—given how much more favorable that bill was to the wealthy than low- and middle-income working families. Extending many of the expiring portions of the 2017 tax law would provide a $500 average tax cut for households in the bottom 60 percent and a $280,000 tax cut to those in the top 0.1 percent.

Nevertheless, the No Tax on Tips Act is deeply flawed; it would leave out the more than 95 percent of low- and moderate-wage workers who are not in tipped occupations. And in many cases, the tax cuts it would provide low- and moderate-wage tipped workers would be small or nonexistent. This is a much worse approach to lifting working families than the American Rescue Plan’s enhancements to the earned income tax credit (EITC) and child tax credit (CTC), which the Biden administration and congressional Democrats such as Sen. Sherrod Brown (D-OH) have proposed making permanent. A single parent with one child making $19,000 in tips and $5,000 in wages, for example, would receive no tax cut from Sen. Cruz’s bill—as shown in Table 1. The restoration of the American Rescue Plan’s CTC expansion, on the other hand, would give them a full $1,090 tax cut.

At the same time, the No Tax on Tips Act contains few, if any, guardrails to prevent high-income professionals such as hedge fund managers from shifting their compensation to a tax-free tipping model. Given the difference in tax rates, the tax breaks from exempting part of these high earners’ income from income taxes would be far larger than any tax breaks for lower-income workers. For instance, a married couple making $1 million in wages could get a tax cut of $180,000 by shifting half of those wages to tax-free tips.

Sen. Cruz’s bill attempts to cover for the regressivity of the 2017 tax law but opens the door to even larger tax cuts for the wealthy.

More than 95 percent of low- and moderate-wage workers aren’t in tipped occupations, and tax cuts for many tipped employees would be paltry

The No Tax on Tips Act provides a deduction for tips from employees’ income taxes, effectively making tips income tax-free. The deduction is “above the line” so tipped workers could still receive it even if they use the standard deduction, like 90 percent of filers. Employers and employees would still each owe a 7.65 percent payroll tax on tipped income, which is far larger than income taxes for low- and moderate-income families

On its face, the No Tax on Tips Act would seem to address these distributional flaws of the 2017 tax law since tipped professions, such as waiters/waitresses and hairdressers, are filled with low-wage workers. Nevertheless, the legislation fails to deliver true pro-working-family tax reform.

First, the vast majority of U.S. workers do not currently receive tips, so they would receive no direct benefits from the bill. Economist Ernie Tedeschi of the Yale Budget Lab estimates that only 2.5 percent of U.S. workers are tipped workers. Among workers making less than $25 per hour—the bottom half of U.S. employees—less than 5 percent receive tips. The bill, therefore, leaves out more than 95 percent of low- and moderate-wage workers, or the bottom half of workers. It leaves out millions of other low-paid workers, such as home health aides, janitors, and cashiers.

Second, exempting tips from income taxes does nothing for tipped workers whose earnings are so low that they are already exempt from income taxes. Tedeschi estimates that more than one-third of tipped employees do not pay any income taxes before tax credits. This means that they would receive no benefit from the deduction. Even among low- and moderate-wage workers who do pay some income taxes, the tax cuts would be small.

Additionally, many parents would receive no benefit from the proposal even if they do pay income taxes because of how the bill interacts with the structure of congressional Republicans’ 2017 CTC changes. The full CTC is $2,000 per child, but congressional Republicans only made $1,700 available to families who do not pay income taxes even if they have significant earnings. This means families need income tax liability to receive the full CTC. In many cases, each dollar of tax cut from an income tax exemption leads to a matching dollar reduction in a family’s CTC for no net tax cut.

Restoring the American Rescue Plan’s EITC and CTC expansions is a better way to help low- and moderate-wage workers

A superior approach to the No Tax on Tips Act is restoring the American Rescue Plan’s expansions of tax credits for working families. Both President Biden’s fiscal year 2025 budget and Sen. Brown’s Working Families Tax Relief Act of 2023 do just this.

For families with children, restoring the expansions would increase the size of the child tax credit from $2,000 to $3,000 per child—or $3,600 per young child—and make the full credit available to low-income families. For low-wage workers without kids, it would nearly triple the EITC while eliminating the current age restrictions that lock young workers and seniors out of receiving the credit.

The No Tax on Tips Act’s biggest tax cuts could be for hedge fund managers, lawyers, and other high-income professionals who game the system

The No Tax on Tips Act contains few, if any, guardrails to prevent employees or business owners from recharacterizing income they receive as wages or business profits as tips. It does not limit deductible tips to workers in specific industries or limit the amount of tips they can deduct. IRS revenue rulings have highlighted the distinction between mandatory service charges and tips so businesses cannot simply charge mandatory service charges that employees can deduct from income taxes.

Yet if hedge fund managers, lawyers, and other highly paid professionals can find ways to restructure compensation as tipped income given the lack of guardrails in Sen. Cruz’s bill, they could enjoy a serious tax windfall. The incentive to recharacterize wages or even profits as tips is stronger for high-income individuals since their income tax rate is higher. For example, as noted earlier, a married couple making $1 million in wages who converts half of their compensation into tips would receive a $180,000 tax cut from the No Tax on Tips Act.

The incentives at play here are far larger than other commonly used tax avoidance schemes high-income individuals already use. For example, private equity managers frequently use the carried-interest loophole, which allows them to pay a 20 percent capital gains income tax rate instead of a 37 percent ordinary income tax rate. Similarly, some business owners take advantage of what is known as the Gingrich-Edwards loophole to understate the portion of their compensation that is wages and increase the portion that is profits, thereby avoiding a 3.8 percent Medicare tax. However, the up to 37 percentage-point tax break from turning wages into tips is far bigger than the 17 percentage-point tax break from carried interest and the 3.8 percentage point tax break from the Gingrich-Edwards loophole.

Conclusion

The No Tax on Tips Act would leave out most low- and moderate-wage workers and provide no or paltry tax cuts to many tipped workers—far smaller than the tax cuts many of these workers would see from Congress restoring the American Rescue Plan’s EITC and CTC expansions. At the same time, Sen. Cruz’s bill would open the door to tax abuse that could provide a windfall to hedge fund managers, lawyers, and other high-income professionals.