Nova workboard

a blog from young economists at Nova SBE

Tips and Taxes

As described in detail by Andrew Schotter (79), tipping is a social convention with economic value. In this comment, I intend to give a brief explanation of the economic gains from this institution and then, in the line of my previous post, present its cost, namely its tax implication.

Whenever regulating the exchange of otherwise trivial services (such as haircuts, meals, etc) would involve negotiating and writing excessively long and costly contracts between client and performer, tipping, by allowing  variable compensation that rewards quality, comes on its own by avoiding these high transaction costs.

For example, when entering a restaurant, it is neither feasible nor cost-effective to design and enforce a contract specifying unambiguously all the conditions of the deal (how many (and how tasty) french fries will be served, the gentleness of the waiter, the quality of the glasses and cutlery, etc). So, except for some characteristics (namely sanitary and safety conditions) that are regulated, we are unsure about the food and the quality of the service we will receive -and because there is no contract, there is no way of litigation either. However, if tipping is instituted (i.e. the waiter expects it and I feel bound to tip if satisfied) there is less need for the extensive contract because both parties implicitly agree that a fixed part of the meal cost will be paid in any case but that the other, the tip, will vary according to the client’s level of satisfaction. In the case of dissatisfaction, the client simply does not tip or pays a smaller tip (and usually does not look for further recrimination). Conversely, the waiter expects to be rewarded for good service.

Furthermore, tipping is an efficient mechanism for the allocation of workers as it promotes self-selection. Again, in the restaurant industry, because of information asymmetries, the employers cannot really be certain of each applicant’s abilities at the moment of hiring. However, setting a payment system consisting of a fixed wage plus a variable component (the tips collected), will dissuade bad waiters from applying, as they know they won’t be able to collect tips enough to cover equal their opportunity wage. On the contrary, good waiters will be keen to accept those jobs, as they know they will receive lots of tips.

So, we conclude tipping is in fact advantageous for the satisfaction of multiple parties in the economy and that it contributes towards efficiency. However, tipping comes at a cost too!

Following my previous comment on the possible decrease of the VAT for the restaurant sector, we can also identify another advantage of restaurants over similar businesses: tips are not taxed! Clearly, if tipping allows for lower prices (as part of the service cost varies according to the client’s satisfaction, and is only paid after the issuance of receipts) then it is reducing the base for VAT, especially when the waiter service is a major part of the added-valued of restaurants. But this does not end here: restaurant owners also pay lower IRS, (tax on income), on behalf of the waiter since this amount is calculated taking into consideration the fixed part of the wage alone. Similarly, lower contributions to social security are paid.

Then, if tipping reduces the amounts of all three taxes paid by restaurants, on top of their known ease of evading taxes (they merely have to declare stocks as having expired), we clearly observe an unfair advantage over similar businesses, namely those who compete for the same workforce but where there is typically no tipping (for instance, shop sales staff: identically not well-qualified but not tipped for their services). This tells us that the real VAT rate restaurants pay is in fact lower and further justifies the previous argument that lowering the VAT for restaurants only is conceding an unfair rent.

Moreover, if we say that, with the present crisis, tipping rates fell (as consumers try to cut spending to minimums), the unemployment increase in the sector cannot be fully explained by the increase in VAT that occurred in 2011.  As tips fell, some waiters left their jobs or demanded higher fixed compensations; this may have led to the closure of many restaurants whose service quality deteriorated or who could not afford higher costs. So, the impact of lowering VAT as proposed by the government will probably be even smaller.

From another perspective, we can look at tipping as an adjustment factor that allowed restaurants not to dismiss employees. After the VAT increase, people knew they had to keep paying tips as long as they were interested in maintaining the previous service quality level (this may be plausible if we believe that the number of employees per restaurant did not decrease much, in this case unemployment is mainly explained by the full closure of many restaurants).

Matilde de Vasconcellos 666


Author: studentnovasbe

Master student in Nova Sbe

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