Why It’s So Hard to Get Rid of Tipping
It’s more than breaking old habits; Government policy makes it nearly impossible for restaurant owners to change how we pay our employees
As a year, 2020 has brought a lot of our society’s buried issues to the surface. Racial justice, economic fairness, the struggles of independent businesses, the exploitative nature of many Silicon Valley “gig” tech giants. One interesting nexus of all these topics has been the issue of tipping at restaurants.
Tipping in the US is a deeply ingrained and unique phenomenon compared to the rest of the world (much like the imperial measurement system). Its racist history has been well documented. Several prominent restaurant owners have moved to abolish tipping (in favor of either a flat service charge or increased prices). Yet as a movement tipless dining has stalled and even gone backwards. Why?
The Twitter-ready response is that restaurant owners are greedy and don’t want to pay fair wages. While one can certainly find restaurant owners who have this mindset, it is neither fair nor accurate. Many owners, especially independent owners, care deeply about our staff and want to pay a fair, livable wage. When we purchased our restaurant in 2019, one of the first things I did was investigate the pros and cons of going tipless. I expected it might cost me a small amount of money, but I hoped it would be something I could manage in the interest of pursuing a more sustainable business model. I was not expecting what I did discover:
For most restaurant owners eliminating tipping is an act of financial suicide.
When I talk with people about the challenges of running an independent restaurant, everyone seems to want to be an expert without knowing anything about how restaurants actually run. Likely because we’re all experts eating at our favorite restaurant, and certainly many of us have worked at restaurants at some point in our lives. (something I think should almost be mandatory national service if only to understand how hard the service industry is to work in). This gives many people the fallacy that they could do it better themselves (spoiler: not likely).
The biggest problem with eliminating tipping is not that it forces the owner to make up the lost wages (although that money does need to come from somewhere). The real problem is state and federal governments have built an entire tax system that not only encourages, but practically requires a restaurant to depend on tips, to the tune of tens if not hundreds of thousands of dollars a year. Not only that, but when a restaurant eliminates tipping everyone loses money except the government, which makes more in taxes when a restaurant goes tipless.
To understand this upside-down result, it’s necessary to dive into some gritty details about taxes. For this article I can only speak knowledgeably about Washington state business taxes; other states will differ, but the end result is likely similar.
Before we start, we need to define what is meant by “taxes”. There are multiple taxes in play that separately affect the customer, the employee, and the restaurant owner. We’ll take these one at a time, starting from an individual customer and working our way up to the restaurant owner.
We also need to define what options a restaurant has if it wishes to eliminate tipping. If the business needs to replace the wages currently paid directly by customers in the form of tips, it basically has 3 options:
- Add a “service charge” (required gratuity, or similar wording), often in the range of 15%-25% of the bill
- Raise menu prices (again usually by 20% or more)
- Eat the cost themselves (pun semi-intended)
Raising prices has obvious problems. The biggest of which is that compared to your competitors you look super expensive. You can post as many signs and notices about a no-tipping policy you like. Hell, you can flash it in 12’ neon lighting. Most people look at a menu and mentally compare the printed price with the restaurant down the street. No one wants to do the math of adding 20% for one restaurant to compare. So just raising prices immediately turns away customers.
Simply absorbing the increased cost (even partially) is also not a workable solution. Many restaurants today are happy to eke out a 10% profit margin. That makes taking a 20% hit in cost untenable.
Keep these in mind as we walk through the practical tax implications below.
Sales Tax
First, we have to talk about sales tax. 45 states charge sales tax on goods and services. In WA, sales tax applies to all charges associated with your restaurant meal, but gratuities (tips) are explicitly excluded from tax collection. WA defines a gratuity as an extra amount voluntarily offered by the customer. If a restaurant eschews tipping for a mandatory service charge, that is no longer a voluntary amount paid by the customer. It has now become part of the bill, and as such is subject to sales tax. This means the customer is now paying more tax on the service charge than if they had tipped the exact same amount.
This same problem occurs if the restaurant chooses to raise prices instead — the added price of the meal results in higher sales tax collection, raising the price of the meal even further.
Let’s use an example to demonstrate. We have two customer receipts: Both for exactly $100 in food and drink. To make the math simple, I’ve set the sales tax rate at 10.0% (Seattle is currently 10.1%) and assumed we have a generous customer who would tip the exact same amount as a mandatory 20% service charge. (You are tipping 20%, right?)
In both cases the customer pays the same final amount: $132. But where the money goes is different. Same meal, same “gratuity”, but with tipping the server keeps $2 more than with the mandatory service charge! The only difference is the state of Washington keeps $2 more of the server’s tip! By eliminating tipping we’ve actually made the server poorer, based solely on the tax code.
For those who would argue that the tip should be based on the pre-tax amount ($20), the core point remains the same: The customer now pays $2 more, which is solely for sales tax. The only person who comes out better is the state of Washington.
But, you say, how many people actually tip 20%? A fair question, although for our restaurant we have generous customers. Our average tip rate is 18%, which interestingly, would give the tipped server almost exactly as much ($19.80) as the mandatory service charge server ($20). In that case, the customer pays less ($2.20 less), and the server makes nearly the same amount. But even if the mandatory service charge is more than the customer may have tipped voluntarily, between the sales tax and other taxes (explored below), the business and server almost always end up worse off.
Business Tax
Next, let’s talk about business taxes. These are taxes the business pays to the state (whether defined as business income tax, operation taxes, etc.). Here Washington state is an outlier, being 1 of 9 states that has no state income tax. In order to generate tax revenue, WA charges all businesses a Business & Occupation (B&O) tax that is based on total gross sales the business generates (not profit). If that seems ridiculous to you, it was to me as well when I discovered it. If I own a business that generates a million dollars in sales (but no profit), I still have to pay B&O tax to the state on the full $1 million, regardless of whether I made money or not. This regressive structure penalizes high dollar, low margin businesses (such as restaurants). Adding salt to the wound is most cities in WA add their own B&O tax. For our restaurant in Seattle, we pay 0.471% to WA State, and another 0.222% to the City of Seattle, for a combined 0.693% tax rate.
Again, voluntary tips are not included in this tax rate. But a mandatory “service charge” or raised prices are taxed, and unlike sales tax, the B&O tax is paid by the business, not the customer. By eliminating tipping, a restaurant owner is now not only having to pay the difference in wages, but now must also pay taxes on these added prices out of their own pocket! So let’s take our earlier comparison bills and see how this affects the business’ taxes. To show how this effect multiplies I’ve extrapolated to assuming an even $1 million in sales per year.
The math adds up quickly. Here we can see that by changing from tipping to service charges (and keeping all amounts equal), everyone ends up losing money except the tax collector.
- The server has lost out on $20,000 in tips ($2.00 times 10,000 $100 checks)
- The restaurant has lost $1,386 in extra B&O taxes
- But the state of Washington has made out with an extra $21,386!
All for providing the exact same meals with the exact same service. All we’ve done is change how we pay the restaurant worker from a gratuity to a service charge. The same math holds if we raised prices instead.
Federal Taxes
Finally, we get to the big issue: federal income taxes. You may assume that I will tell you that tips can be easily hid from income taxes, resulting in more money for both the employee and the business. You would be wrong. First, on principle, we operate above-board. Second, in today’s society, 99% of our customers pay by credit card. There’s no way to hide a paper trail of tips, and we report all tips (cash and credit) on our employee’s paychecks.
The US federal tax code contains a huge incentive for restaurant owners to report tips: The FICA Tip Credit. FICA (Federal Insurance Contributions Act) is the official name of your Social Security and Medicare taxes. Half of these taxes are paid by the employee, and the other half by the employer.
Established in 1993, the FICA Tip Credit recognizes that employers may need an incentive to report employee tips on their paystubs. As long as the employee’s tips exceed $5.15/hour, the employer gets a tax credit for their portion of FICA taxes paid on tips. Not an income deduction, but rather a full tax credit. That is a dollar-for-dollar refund of taxes paid.
This is a huge financial benefit to the restaurant owner and can sometimes make the difference between profit and loss for a year. Let’s see how this adds up for an entire year.
First, we have the tip credit itself. Our restaurant owner who continues to use a tipped business model saves $16,830 on his income taxes for the year with the FICA Tip Credit. Our service charge owner loses out.
But wait, there’s more! Remember how our service charge server lost out on $2.00 per bill? It’s not as if they’re going to be happy about making $20,000 less for the year (our mythical server who did a million in sales themselves). If you’re a well-intentioned restaurant owner who wants to make up the difference, that means you must pony up another $20,000 in wages, plus the employer taxes on top of it. That adds up to a combined cost of $36,830 just by eliminating tipping.
If you add in our extra B&O taxes above, plus other various employment taxes that are earnings-based (unemployment taxes, workers’ comp, etc.), and you easily get to an extra $40K in costs by eliminating tipping. And in this scenario, the server ends up making the same amount of money. The only person who loses here is the restaurant owner, to the tune of 4% of their profit margin! If you expand to operate multiple restaurants, it’s easy to see how this quickly adds up to hundred of thousands if not millions of dollars. That is money that could be spent on health benefits, higher wages, or even put aside in preparation for the next pandemic.
Even the most well-intentioned of owners does this math and concludes it would be lunacy to make this switch. No one’s lives have been made better, there’s been no fairer distribution of pay, no racial equity accomplished. All we’ve done is cripple a business and paid more taxes. It’s no wonder that nationally-known operators such as Danny Meyer have been forced to retreat from eliminating tipping. When it’s the difference between continuing to operate and failing, the math always wins.
You may notice that not once in this article have I discussed topics such as minimum wage, front vs. back of house wages, tip pooling, or other ideas designed to help improve the economic safety of restaurant workers. These topics often get intermixed with tipping. Many people assume that tipping is a bygone artifact with a racist origin that simply needs to be eradicated to improve the living situation of millions of restaurant workers. While a great story, it has little basis in reality. The reality is that tipping has become the bedrock foundation for millions of restaurants, and you cannot yank it away without creating something to replace it. If it were easy, it would have been done by now.
This is not to say that there aren’t serious racial and gender equity issues within the hospitality industry. There are and have been for some time. The COVID-19 pandemic has given us a once in a lifetime opportunity to reexamine our business models and experiment with new ways of sharing the success of our business with the people who make it possible: our amazing staff who (never forget) are risking their lives day after day to provide meals and service to the general public during this pandemic. They deserve to be well paid for their efforts. This is something we continually try to examine and improve.
The fact is that before we can eliminate tipping in restaurants we need to understand the role it plays in keeping our favorite eateries afloat. It is a Gordian Knot spanning local, state, and federal tax policy that are all interconnected and interdependent. You cannot unravel it in one place without pulling that thread out of a larger tapestry with unexpected consequences. My goal with this article is to provide a numbers-based view into the practical impacts tipping has on the financials of restaurants. We cannot discuss eliminating tipping without considering the ripple effects it will create across a business and industry.
I argue that the current federal tipped minimum wage of $2.13/hour is an atrocious insult that basically forces people into indentured servitude. It’s practically slave labor. While I may complain about Seattle and Washington taxes and regulations, we operate in a tipped minimum wage of $13.50/hour (soon to be $15.00/hour). If we are going to maintain a difference between tipped and untipped minimum wages, we need to set them at a realistic level that allows people to earn enough to survive. It doesn’t need to be Seattle rates, but that’s why we have local governments, to debate and determine the appropriate minimum wages for our communities.
If we’re going to have a discussion about economic fairness and racial equity, we should be focusing on how much people need to earn to survive and succeed, not whether they earn it as tips or wages. Those who argue that eliminating tipping will somehow result in economic equality are not knowledgeable of how tipping works or how it’s treated in our tax code. It’s easier to advocate for something like eliminating tipping than the harder political argument of raising the minimum wage. The former only addresses how people are paid, the latter is the harder discussion of how much people need to earn in our society to be successful.
There are plenty of issues with depending on tips for income. Wage theft, unconscious bias, and other factors are serious problems that are illegal, immoral, and harm thousands of workers. But if we do want to eliminate tipping, we need to understand the ripple effects of that decision, not only for workers, but for the businesses that are struggling to both survive AND provide economic security for their employees. The only thing guaranteed by eliminating tipping on its own is it will wreak havoc throughout an industry already struggling to survive, while adding nothing to the pockets of restaurant workers.
Charlie Anthe is the co-owner of Moshi Moshi Sushi & Izakaya in Seattle, WA.
