During his years in Congress, Campaign for Liberty Chair Ron Paul worked to reduce taxes on working Americans. One of Dr. Paul's most notable initiatives in this area was his legislation to reduce taxes on tips.
I was reminded of this when I came across a fascinating article on Mises.org by Dr. Ken Zahringer, Research Fellow in the Division of Applied Social Sciences at the University of Missouri:
So why do we tip? At first glance it seems rather odd that a waiter should be paid by two different people — employer and customer — for the same job. But in fact we, as tipping customers, are paying for a very different aspect of the waiter’s job than is the employer. The restaurant owner needs a way to get the customer’s order to the kitchen and the food out to the customer. Most anyone who can walk a straight line and operate a pencil can perform that task. But the restaurant owner also wants happy customers, and customers are happy when they have a waiter who can solve problems, handle special requests, and generally make their meal a pleasant experience, and that is a special skill set indeed. Coordinating these two different, and not closely connected, aspects of the job is what tipping is all about.
Information Asymmetry
The employer wants happy customers, but he has a twofold information problem. As a practical matter it is difficult for him to observe interactions between waitstaff and customers. In addition, the customers’ expectations regarding the quality of service are impossible to observe. This is further complicated by the fact that staff members are heterogeneous; they are different in terms of skill levels, personalities, and other characteristics that affect the customer’s experience of quality service. Thus the employer doesn’t have the information he needs to arrive at an appropriate wage for each member of his staff. The customer, however, is a participant in these interactions and as such has as complete information as is humanly possible. If the customer pays the server directly for that aspect of the job, the decision of the appropriate pay is made by the person with the most information about job performance.
Incentive Alignment
Employers generally want their employees to give their best, and presumably are willing to pay for that. However, the aforementioned information problem inhibits his ability to do so. Ideally, tips make the server’s compensation directly proportional and immediately responsive to the quality of service provided. This aligns the employee’s incentives with the employer’s; both now want to provide high-quality service to the customer, each for their own benefit.
Risk Sharing
Hiring a new employee entails risk. For the new employee, there is the risk that the job may not turn out as he had hoped. It could turn out to be a dead end with no future, or unsatisfactory in innumerable other ways. The employer, however, has a financial risk. The new employee’s skill set is unknown to the employer to at least some degree, regardless of how thorough the interview process might be. There is even more uncertainty with an inexperienced new hire; there is no history for the employer to work from. The employer has to pay the agreed upon wage, and if the new employee doesn’t perform as hoped he is losing money. If the new employee accepts a lower guaranteed wage and makes part of his compensation contingent on performance — the tip — this relieves risk in two ways. First, the employer is more willing to take a chance on a young, inexperienced worker. If the wage is lower, the minimum performance level needed to make the employee worth the wage is also lower. Second, since the employee can increase his earnings directly and immediately by improving his performance the job is not so much of a dead end. The low paying job becomes a valuable stepping stone, allowing the young, inexperienced employee to learn job skills, establish a performance record, and move on to something better. (It should be obvious that minimum wage legislation short-circuits this entire arrangement, making the employer much less willing to hire someone unless he is certain they are worth the higher wage. This is how lower-skilled individuals get shut out of the job market. But that’s the subject of another essay.)
Read the whole article here. Also see Dr. Zahrngier's article on Uber and the Economics of Tipping, and Bob Murphy's In Praise of Tipping.
The argument that tipping provides a way for business owners to encourage their employees to provide excellent service to their customers supports Dr. Paul's case for not taxing tips as wages. Tips are not part of a workers wages, since in most cases a customer is under no formal obligation to tip (they may feel an obligation to leave a tip because of social custom even if they where dissatisfied with the service--although someone who gets sub par treatment is likely to leave a smaller tip then someone who receives exceptional service .)
Since taxing tips reduces the amount a worker can get from tips, taxing tips reduces the incentive to provide excellent services, thus taxing tips damages consumers as well as employees.
Here is Dr. Paul's official statement on the Tax Free Tips Act:
THE TAX FREE TIPS ACT
______
HON. RON PAUL
of texas
in the house of representatives
Wednesday, March 16, 2011
Mr. PAUL. Mr. Speaker, I rise to help millions of working Americans
by introducing the Tax Free Tip Act. As the title suggests, this
legislation exempts tips from federal income and payroll taxes. Tips
often compose a substantial portion of the earnings of waiters,
waitresses, and other service-sector employees. However, unlike regular
wages, a service-sector employee usually has no guarantee of, or legal
right to, a tip. Instead, the amount of a tip usually depends on how
well an employee satisfies a client. Since the amount of taxes one pays
increases along with the size of the tip, taxing tips punishes workers
for doing a superior job!
Many service-sector employers are young people trying to make money
to pay for their education, or single parents struggling to provide for
their children. Oftentimes, these workers work two jobs in hopes of
making a better life for themselves and their families. The Tax Free
Tips Act gives these hard-working Americans an immediate pay raise.
People may use this pay raise to devote more resources to their
children's, or their own, education, or to save for a home, retirement,
or to start their own businesses.
Helping Americans improve themselves by reducing their taxes will
make our country stronger. I therefore hope all my colleagues will join
me in cosponsoring the Tax Free Tips Act.
Print 
PDFTags: Ron Paul, Austrian Economics, tax free tips, Mises