Biting The Hand That Feeds You

Service at your average German or French cafÈ can seem awfully unfriendly to the US tourist - unless he's from New York, and accustomed to the bitter brush-off. Why doesn't the French waiter rush over to top up your coffee like Sue at the diner in Smalltown, USA? One reason for the disparity is that service charges are set in Europe, so the servers have little incentive to deliver that espresso in a timely fashion. They get the same money - or close to it - whether they smile or not.

Now, however, another set of American servants - those who sit on the Supreme Court - have arranged matters so that a meal at the local diner will become more like one in grumpy old Europe.

At issue is the court's ruling in United States v. Fior D'Italia, handed down on June 17. Fior d'Italia is a San Francisco restaurant, and by siding against it, and for the Internal Revenue Service, the Supreme Court assailed the one lever customers have to influence service at their favourite gastronomic establishment: tipping.

The story starts with taxes. Since the second world war, the IRS and its forerunner, the Bureau of Internal Revenue, have had a sure means of collecting taxes on the paper earnings of restaurant workers - they do it by withholding.

But it's been harder for the IRS to lay its claim on payroll taxes for the share of servers' earnings that comes in tips. And in America, unlike Europe, a substantial portion of a waiter's earnings do come that way. (Americans tip between 10 and 20 per cent, unless they are furious and brave. Then it's zero). That 10 percentage point range has been beneficial to both employees and customers.

Employees like it because they can bring in sweet tax-free cash. Employees and restaurants have often have a "don't ask, don't tell" policy, which frees workers to pocket tips untaxed. Untaxed tips may be illegal, but their lure is part of what makes many unskilled Americans want to work. That is something you would think the Feds would want to leave undisturbed, since they spend billions of dollars a year on tax and welfare-to-work programmes written to achieve precisely the same goal.

Customers like tipping because they can reward good service or punish the waiter who dropped the lobster. This is a big part of the American "customer is king" culture, and a powerful one.

Naturally, the Feds have, over the decades, sought to grab their elusive share of the tip booty. Still, much has gone unreported. In the Fior d'Italia case, summed up on the National Restaurant Association webpage (, the IRS reviewed the restaurant's credit card receipts, finding a tipping rate that averaged a little over 14 per cent. Then it presumed the same rate on cash revenue, and concluded that workers had failed to report $304,000 in income for a two-year period. It charged the restaurant for back taxes of $23,262 (FICA of 7.65 per cent).

In its 6-3 ruling, the high court gave the IRS the authority to go after such unreported cash by estimating the amount of cash tips that go to employees (for details on the jurisprudence see David Lui-Sher's story in the June 24 issue of Tax Notes). This will have several unpalatable consequences. The first is that restauranteurs may owe a lot of back taxes on unpaid employee FICA.

"There's the possibility that the IRS could assess restauranteurs back to 1988, the year when federal law imposed FICA tax on employers on tips," says Peter Kilgore of the National Restaurant Association, which helped pay Fior d'Italia's legal expenses. "For a small restaurant, which operates fairly close to the margin this could affect financial viability." Bye bye bistro.

Then there is the fact that the collector, in this instance, is not likely to be the IRS. It will be the restaurant. As dissenting justice David H. Souter wrote, the ruling "saddles employers with a burden unintended by Congress". This is bad news on the unemployment front, for it affects principally low-wage jobs, those most sensitive to incremental changes in the employment market. Employers will be a little less generous in creating new positions when they know they have to chase after waiters, demanding their tip figures.

"One of the fall-outs of this decision is that employers may feel compelled to become the tip police, browbeating employees," says Mr Kilgore. In other words, the congeniality of restaurant culture will be eroded.

Most damaging of all, employees will be less likely to bid for extravagant tips through extraordinary service, knowing they will now pay taxes on the extra money. To them this feels like an increase on their marginal tax rate, something our lawmakers tell us they only impose on "the rich". The restaurant industry is seeking redress in Congress.

The general point here is not that the Feds don't deserve the money. It is that when it comes to dining, what happens on the margin affects every tiramisu - yours too.

© Copyright 2002 Financial Times

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