The individual income tax has plenty of problems, but in some respects the tax has improved in recent decades. Unfortunately, several Trump administration proposals would move us in the wrong direction, including the president’s call to drop taxes on tips.
Back in the 1950s, the tax code featured sky-high marginal tax rates and ample opportunities to avoid them. The top marginal tax rates was higher than 90 percent for part of the 1950s (even though only a narrow sliver of taxpayers were subject to it). But the marginal tax rates on ordinary taxpayers were high, too. In 1953, the bottom marginal tax bracket was 22.2 percent; today, it’s 10 percent.
Despite these much higher taxes on paper, tax revenue as a share of GDP throughout the 1950s was roughly the same as it is today. How do we still collect the same level of revenue with much lower rates? Because of reforms that brought rates down and expanded the base.
The tax treatment of tips is a microcosm of this trend. Officially, tips were always considered taxable income. But given the relatively small size of tipped income relative to the whole tax base and the absence of third-party reporting, the IRS largely turned a blind eye to widespread tax evasion. That is, at least until 1982, when a new law introduced some reporting requirements for tipped income. While nonreporting of tipped income remains an issue, the gap has fallen substantially since these changes.
The largest legislative accomplishment of President Trump’s first term, the 2017 Tax Cuts and Jobs Act (TCJA), also simplified the tax code by limiting deductions. The TCJA limited state and local tax deductions and the mortgage interest deduction, while eliminating a handful of miscellaneous smaller deductions, to help pay for individual rate cuts. The tax cuts are set to expire at the end of this year. Prioritizing breaks such as making tips tax-free, rather than concentrating on extending the rate cuts and base expansions of the 2017 law, could reverse those gains.
The Tax Foundation has estimated that eliminating taxes on tips would cost $118 billion in revenue over 10 years. That estimate comes with significant uncertainty. Presumably, taxpayers would try to shift as much of their compensation to tips as possible, including in industries in which tipping is not currently the norm. For tips to be tips, though, customers must voluntarily offer them. We assume the policy would lead to a 10 percent increase in tipping, but it could be much higher. Policymakers could also limit the potential runaway costs of the policy by restricting it to tips earned in historically tipped occupations or limiting the amount of tipped income eligible for the exemption.
The income tax is not perfect today by any means. There are still legal holes in the tax base, and there is still illicit tax evasion. But at a very high level, we have been moving in the right direction since the 1950s. The debate over TCJA extension could and should be an opportunity to expand upon those successes and further simplify the tax code, rather than carve up the tax base.
Alex Muresianu is a senior policy analyst at the Tax Foundation.
Governing’s opinion columns reflect the views of their authors and not necessarily those of Governing’s editors or management.
