Presidential candidate Donald Trump has put forth proposals to exempt tips and overtime from income taxation. These exemptions would almost exclusively benefit low- and middle-income households. Examining the economic consequences of these proposals is a worthwhile exercise.

Incentives drive economic behavior. Encourage an activity, and we get more of it. Discourage it, and we get less.

These tax exemptions dramatically increase the incentive to work for low- and middle-income households because they will keep more of their wages. They are virtually worthless to higher income households, for example, because they don’t wait on tables.

Why focus on low- and middle-income households?

We have established a fabulous social safety net with Social Security and programs established since WWII. Including the top 100 Federal programs, lowest-income households (lowest 20%) receive over $45,000 in cash and “in kind” benefits.

Contrary to popular myth, which counts only cash payments, poverty has been reduced to 2.5%.

Benefits decline as a household works more and raises itself out of the lowest income 20%.

In the next 20% of household income, the benefits decline by $15,000.

In the next 20%, which takes us into the middle class, it declines by another $12,000. Benefit programs are means-tested — benefits decline as household earnings increase.

As an unintended consequence, means-testing reduces the net reward a household receives from work because the household also gives up some safety net benefits when it earns more.

This decline poses a significant disincentive to work. For example, the lowest 20% of households earn less than $5,000, but receive more than $45,000 in cash and in-kind benefits.

A household that works and moves into the next 20% earns almost $31,000, but sees their benefits decline by $15,000. So, the net gain to the household is only $16,000.

Working into the middle 20% means earnings of over $66,000, but a further decline of $12,000 in benefits. This is means-testing doing what it is supposed to do, but the disincentive to work is also clear. (Data taken from “The Myth of American Income Inequality,” Phillip Gramm, et.al, 2022, pages 17 and 37).

So, what can be done to help households as they work their way out of our generous social safety net?

Why not provide greater incentive to work by not taxing certain types of income mostly earned by those in that situation?

Not taxing tips would increase the incentive to pursue a part-time or full-time employment as a server. That would increase employment and worker participation, which declined dramatically during the pandemic and has not fully recovered yet.

Why not exempt overtime wages from income tax? Doing so would increase the incentive for those eligible to work more hours.

The wage earner benefits by earning more and keeping all of it. Consumers benefit from the additional production of goods and services. These Trump proposals strike me as smart tax policy.