Our economy is plagued with the unintended consequences of short-sighted policies.
Are the ideas sound?
A s the 2024 presidential-election cycle heats up, the candidates are throwing out proposals designed (primarily) to attract voters. Donald Trump has suggested various tax cuts, and three of those have garnered much attention, both positive and negative. Below is my analysis of those three major ideas that Trump has tossed out (beyond his commitment to extend much of the Tax Cuts and Jobs Act).
Eliminate Taxes on Tips
During a campaign stop in Nevada, Trump pledged to eliminate taxes on tips. At present, tip income paid to service workers is treated just like wage income. It is subject to income tax on the part of the employee who received the tip, and employers must pay employment taxes on the tips their employees receive. Shortly after Trump made this announcement on tipped income, Senator Ted Cruz of Texas introduced legislation in the Senate to push the idea through Congress, and a number of other Republican senators have gotten behind the idea.
Under Cruz’s bill, employees receiving tips would be allowed a deduction on their tax return in an “amount equal to the cash tips” received during the year. Those who don’t itemize deductions would be allowed a special line-item deduction. The IRS would also be required to amend its withholding tables to take into account the new exclusion. From the bill, it seems as though employers would not receive any relief from the employment-tax liability imposed on the tip income; indeed, the employer would still be required to report the tips to the IRS, and that is the means by which the amount of the deduction is determined.
There is a long line of court opinions, such as Mendelson v. Commissioner, holding that tips earned by service providers are taxable income — not gifts or gratuities. The determining factor is that a tip is paid only in connection with services rendered in the course of a commercial transaction, whereas a gift or gratuity is given without any expectation of return and outside of an otherwise commercial transaction.
Trump’s proposal would change long-standing law, which is fine by me. I’m in favor any tax cut, wherever it might show up. However, from my reading of the bill, the tax break covers the employee and not the employer. If tips are not taxed, the employer should be similarly relieved of the burden.
The IRS has gone to great lengths over the years to ascertain the amount of tips earned by workers, and ensure that those tips are accurately reported. During the 1980s, the IRS even went so far as to plant undercover criminal investigators into businesses with traditional high levels of cash transactions and service workers. The IRS’s Las Vegas and Atlantic City casino-tip projects are examples.
The problem with Trump and Cruz’s idea is not the tax cut itself. The problem is the market distortion that the tax cut will likely create. First, the cut is aimed at workers primarily in the hospitality industry where tips are most prevalent. But certainly they aren’t the only people in the service industry. Service workers cut through all elements of the economy, from package-delivery services, to home-care services of every description, to tech services, and so on endlessly. Are they going to be covered by the tip exclusion? Tips received by such workers are typically not shown on Form W-2. Such workers are responsible to record and report their tips independent from their employers. With no tips shown on the W-2, will they be denied the deduction?
And, most significantly, will employers in traditional tip-intensive businesses (bars, clubs, restaurants, etc.) significantly reduce wages? Will they push to encourage employees to work only for tips? And how will state and federal minimum-wage laws bear upon the discussion? Tax-exempt tips constitute an immediate tax-free pay raise equal to the amount of tax the worker would otherwise pay. Will that count against a minimum wage? On the other hand, I can easily imagine a significant hike in minimum-wage laws in an effort offset the revenue lost by exempting tips from taxation.
Vice President Harris offered an idea to exempt tip income. However, she hasn’t yet provided details.
Eliminate Taxes on Overtime Pay
In September, Trump announced that he would eliminate income taxes on overtime pay. He stated that overtime workers are “among the hardest working citizens in our county.” No further details were offered by Trump, nor (as of this writing) has any bill been introduced in either the House or the Senate.
Such a proposal may have the same administrative problems identified above. For example, will employers remain liable for the employment-tax liability currently imposed on overtime pay? I assume yes, since such pay is currently treated as wage income.
And what might be the economic distortions created by such a plan? In the first place, will the federal government provide a universal definition of what constitutes a “normal” workweek, and therefore, what qualifies as “overtime” pay? Will Congress seek to define a “normal” workweek as constituting 55 hours, and overtime occurs only after that? I’m sure America’s unions would never support such a proposal.
And if there’s no universal definition of a “normal” workweek, would individual employers then be free to declare that their “normal” workweek consists of just 20 hours? In that case, imagine the incentive for workers to seek employment at such a company, and further imagine the pressure put on other employers to match that definition.
Eliminate Taxes on Social Security Benefits
The taxation of Social Security (SS) benefits is based on complex calculations that can result in up to 85 percent of one’s SS being taxed in a given year. To oversimplify, it boils down to a question of how much income the taxpayer had during the year, independent of SS benefits. Very generally, taxation of SS kicks in at $44,000 (of other income) for married persons filing jointly, and $34,000 for single people.
You can thank President Bill Clinton for the current level of SS taxation: The Tax Reform Act of 1993 increased the tax ceiling from 50 percent to 85 percent. The law also increased the top marginal income-tax bracket from 36 to 39.6 percent, although that was changed under the TCJA and might be resuscitated in a Harris administration.
At present, approximately 67 million Americans receive SS benefits. Benefits are not paid by the government out of a bank account in Washington with your name on it into which you contributed over your working life. The SS withholding taken from your paycheck (or imposed on you as a self-employed individual) were not (and are not) “contributions” to a retirement plan in your name. The SS deductions were (and are) taxes imposed under Internal Revenue Code section 3101. The opening sentence of that section reads, “In addition to other taxes, there is hereby imposed on the income of every individual a tax equal to 6.2 percent of wages. . . .” (Emphasis added.)
The proceeds of the tax on wages that we call SS “contributions” go into the general fund. The revenue is used to pay government expenses generally, and it makes up a substantial portion of the payments to current SS beneficiaries. The SS program was sold to Americans as a retirement plan when, in fact, it’s no such thing. Instead, it’s an elaborate subsidy that requires current beneficiaries to live to the next month in order to get a check. Consider this: You can “pay into” the system for 40 years, but if you die one month after retiring, your heirs get nothing. Your surviving spouse might get a paltry one-time “death benefit” of $255 (that’s not a typo).
Taxation of SS benefits didn’t start until 1979, when Congress under Jimmy Carter decided to include up to 50 percent of SS benefits in taxable income. Before that, SS benefits were not subject to federal income tax. The taxation of SS benefits was a sleight-of-hand way for Congress to reduce the cost of SS benefits while leaving their nominal value unchanged.
In sum, we’ve been tinkering with the tax code for so long that we now have nothing but a mess. Much of the code exists because of its use by Congress to achieve goals entirely unrelated to collecting the revenue needed to fund the legitimate functions of government. As a result, our economy is plagued with the unintended consequences of short-sighted policies. Unintended consequences are the bane of hasty tax and economic policies.