Adam N. Michel
Last year, Congress passed a major tax and spending package that, among many other provisions, introduced new income tax deductions for tips and overtime pay. These changes are the subject of a new Cato Institute Briefing Paper.
On their face, the provisions are politically popular. In a March 2025 survey, we asked Americans whether they supported eliminating taxes on tips. Sixty-one percent agreed that it is important to cut taxes on tips earned by servers, hairstylists, and other tipped workers. Respondents also expressed favorable views toward adding or expanding other forms of special tax treatment.
In the same survey, Americans expressed a seemingly contradictory view. Nearly three-fourths (74 percent) said they prefer lower tax rates paired with the elimination of “most tax deductions and tax credits.” In a similar Tax Foundation survey, large majorities of Americans said that the tax code is too complex, unfair, and in need of reform.
People tend to like individual tax carve-outs in isolation, but they dislike the accumulation of those carve-outs that turns taxpaying into a time-consuming, costly, and frustrating process.
That tension is exactly what the new Cato brief explores. It also provides an overview of the new tax deduction rules, their economic and budgetary effects, and recommendations for Congress when they expire.
So, what’s the cost?
Eliminating taxes on tips and overtime reduces federal revenue by about $30 billion per year, or roughly 1.1 percent of total income tax receipts. That’s not enormous, but the real problem isn’t one or two provisions. It’s the accumulation of more than 170 similar targeted carve-outs.
The 37 largest income tax deductions and exclusions, including those for tips and overtime, reduce income tax revenue by almost $700 billion every year. That’s where complexity, unfairness, and economic distortions really start to add up.
If policymakers closed all those largest loopholes and used the revenue to cut tax rates, the results could be dramatic. Our back-of-the-envelope calculations suggest that $700 billion in base broadening could support an average 27 percent cut in tax rates, lowering the top rate from 37 percent to about 27 percent and the bottom rate from 10 percent to about 7 percent. Because the economic cost of a tax increases exponentially as tax rates rise, a reform like that could cut the economic damage of the income tax nearly in half, saving roughly $600 billion per year in economic costs.
The brief also describes the mechanics of the overtime and tip deductions and their likely economic and distributional effects. Finding that rather than encouraging additional work, they primarily reward the reclassification of income, impose new compliance burdens, and distort work decisions.
No tax on tips and no tax on overtime may be well-intentioned and politically popular, but they are also a textbook example of how the tax code grows more complex, less neutral, and less efficient over time. When the provisions expire after 2028, Congress should resist calls to extend them. If lawmakers are serious about helping workers and boosting growth, broadening the tax base and lowering rates would do far more than carving out yet another exception to the tax rules that apply to everyone else.
You can read the full report here: New Income Tax Deductions for Tax-Free Tips and Overtime