Why people tip in US restaurants

Here, I’ll discuss a tax incentive by the federal government to encourage bosses to have employees paid via tips instead of a typical wage.

The waitress is the only person who knows how much she got tipped. [I flipped a coin to write this example, and she came up female]. And, unless she’s in the narrow band where EIC (earned income credit) kicks in, she pays out a tax on those tips and so wants to understate her tip income.

Typically, employers pay payroll taxes on income, meaning social security tax (6.2%) and medicare tax (1.45%). In such a case, her boss would be very OK with her under-reporting her tips.

To give a more precise example, say that the boss pays the waitress the minimum wage, but she takes home $20/hour in tips on top of that. She works a typical full time of 2,000 hours/year, so she takes home $40,000 in tips. Payroll taxes, totalling 7.65% of $40k, would be $3,060. That’s a $3,000 incentive for the boss to write down a small number on the waitress’s W-2.

For the IRS, the big problem is the waitress. Reporting herself at minimum wage, she gets a refund of $689 (thanks to EIC); reporting all income, she pays $6,906; for a total swing of $7,595. So the IRS’s goal in this game is to get the waitress to pay taxes, in opposition to the goal of both the waitress and the boss. If you expect that the waitress is making less money than the business owner, then this is a case where the IRS does better going after the poorer person.

The official record of tips is not what the waitress says she has in her apron at the end of the day, but the W-2 that the boss prepares. So the IRS offers the boss a credit on payroll taxes. Whatever tip income the waitress reports (past minimum wage), the boss pays zero payroll taxes.

[Formally, he pays the payroll taxes, but then reclaims the taxes as a credit when he fills in his annual taxes. I’ll get to how this can create some exceptional cases later, but in the typical case, this is a full refund of all payroll taxes associated with above-minimum tips.]

Form 8846: Credit for employer social security and medicare taxes paid on certain employee tips

I asked myself, what’s the most exciting image I could put on this blog about restaurants and waiters?

With this arrangement, the boss is a neutral party, and has no reason to tell the waitress to hide her income or lie about it himself when he prepares her W-2. There may also be incentives in how the restaurant operates to get her to be forthright about her tips.

Next year, the owner reads this enthralling series of articles about no-tip  restaurants, and decides that he’s going to do it: instead of expecting customers to calculate 15 or 18 or whatever percent, he’s just going to add 18% to the price listed on the menu. Customers eat, pay what the menu told them to pay, and leave. The waitress gets paid $25 for an hour of work, and if the business does badly or well it’s the boss’s risk, not hers. When it was a tip-oriented restaurant, the waitress always knew that if she was an inexcusable slacker and ignored tables, the boss would fire her, and that doesn’t change once she’ll be getting a fixed wage like everybody else with a job. Say goodbye to customers who think 15% of $50 is $5, explaining to Europeans that they shouldn’t leave the tip line blank, all the weirdness about splitting tips between the waitress and the kitchen, all the creepiness of customers who think they own the waitress and can be jerks because they’re leaving a $5 tip, it’s all delightfully out the window.

So he calls his accountant and tells him that everything is going to be a lot more simple from here on in. And his accountant points out that simplifying the experience for his customers and employees is going to cost $3,000 per waiter per year in un-refunded payroll taxes. Our imaginary restauarant has five waiters, so the owner has to decide whether his experiment is worth an up-front loss of $15,000/year. Knowing the margins of the restaurant business, and knowing the limits of how many expenses can be passed on to somebody buying a ten dollar burger, that ends the story right there.

The tip credit is a clear incentive for a custom that a lot of people would be fine seeing gone. If tipping were not a concept today, it’s hard to imagine a restaurant pitching customers that they’ll have a better time because they can pay less for food but must leave a variable wage payment on the table. The credit is an incentive for compliance, where in most parts of the tax code the only incentive for compliance is that you won’t get arrested. As we’re drifting toward an economy where every payment involves electronic access to an account, it seems that the problem of under-reporting of tips is on its way to obsolete. But the tip credit is a nice example of the sort of tax that divides the population into restauranteurs who benefit from the tax and everybody else who has no idea that the tax exists, so it is unlikely to go anywhere any time soon.


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