Evidence from Montana suggests charging income taxes on tips has implications for the labor market and the ability for some small businesses to retain employees
Key Findings
- When Montana started taxing tipped wages, tipped employee attrition increased by 81%, meaning that eliminating taxes on tips could increase employee retention at small businesses. As Congress considers removing federal income taxes on tips, they’re considering a pay increase for tipped workers. An increase in take-home pay could reduce attrition and more employees may decide to remain at their current employer.
- Montana’s tip tax raised small business costs by $8,000 annually—just from higher employee turnover. Congress’s tax on tips proposal will mean significant savings for small businesses through increased retention. Currently small businesses pay about 26% of an employee’s annual salary to replace them. These turnover costs include things like lost productivity and the search costs associated with finding a new employee.
- Restaurant employees were the least affected by Montana’s tax change, suggesting that eliminating federal taxes on tips may not significantly impact turnover in this industry. No statistically significant relationship on tipped taxes and restaurant employee attrition rates was identified. This suggests that, even under a different tax policy, restaurant employees make a comparatively higher income than other tipped industries and will be unlikely to change jobs.
Introduction
Congress is currently considering a policy to eliminate federal income taxes on tips. While much of the discussion has centered on its implications for worker pay and the federal budget, this policy also has important consequences for small business owners. By increasing take-home pay for tipped workers, the proposal could strengthen employee retention—effectively giving workers a raise at no direct cost to employers.
Although no state has previously removed taxes on tips, Montana provides a useful case study by doing the opposite. As of January 1, 2024, Montana began taxing tips for the first time, reducing take-home pay for tipped workers. While this is not a perfect mirror of the federal proposal, it allows us to observe how changes in tip taxation influence worker behavior. Montana’s policy led to an 81% increase in attrition among tipped employees, suggesting that eliminating federal taxes on tips could improve retention, even if not to the same extent. This provides small businesses with a rare, real-world indicator of how a change in tax policy might impact their workforce.
Our analysis informs the way that Montana’s change in tax policy is related to the probability that an individual tipped worker leaves their job. When thinking about tipped workers, most consumers immediately consider employees at full-service restaurants. However, previous Gusto research shows that tipping is on the rise across different industries. Montana is no different. While 48% of our sample includes restaurant workers, 15% include Hospitality, Health, Wellness, and other Personal Service workers; 10% includes retail workers; 25% of tipped workers are spread across different industries. We observe tipped workers in fields like agriculture (2%), manufacturing (3%), and consulting (1%) among others.
Employee retention dropped by 81% when tips were taxed
While the probability of an employee leaving their job in any given month is low, changing the tax structure in Montana – and ultimately decreasing take home pay for tipped workers – is correlated with an 81% increase in the chances that a tipped employee would leave their job. This is true even after accounting for county economic effects, the business, and the business’s industry before Montana implemented a tax on tips policy.
This significant tax advantaged income likely means that many employees kept their tipped jobs because of the higher earnings compared to non-tipped jobs where all income was taxed. Replacing an employee typically costs between 20% and 200% of the employee’s total wage, and small businesses that paid tips were much less likely to incur these costs.
As Congress considers eliminating taxes on tips, Montana’s experience offers useful insights. If taxing tips drives workers away, removing taxes on tips at the federal level should improve retention. However, behavioral economics suggests that businesses should not expect tipped employee retention to increase by 81%—people react more strongly to losses than to equivalent gains. Additionally, one of the current proposals excludes independent contractors or gig economy workers, a growing share of the tipped workforce. As of 2021, 16% of U.S. adults—and nearly one in three under 30—had earned income as independent contractors. This exclusion means many gig workers doing the same tipped jobs as W-2 employees would see no benefit.
While eliminating tip taxes will likely reduce turnover, businesses should not expect an 81% surge in retention. Instead, they should anticipate a meaningful but more modest improvement, particularly in industries where tipping makes up a large share of total compensation. Small businesses continue to report difficulty filling open positions. Even a modest boost in retention could help small businesses reduce costly turnover and ease persistent hiring challenges.
Montana’s tax on tips cost small businesses up to $8,000 per year
Increased attrition cost small businesses about $8,000 per year after Montana implemented a tax on tips policy. On average, replacing an employee costs 26% of their annual pay, though some estimates go as high as 200%. These costs include the search costs for a new employee, any signing bonus that might be required to entice an employee to join the team, and lost productivity due to the business being short staffed.
The average tipped employee in Montana makes about $32,000 per year. We can estimate the total cost by looking at how many extra workers left, how much it costs to replace each one, and the average wage of tipped employees. While exact costs vary by industry and location, the Montana law ultimately added about $8,000 in turnover costs per small business.
Nationally, eliminating federal income taxes on tips could ease these costs for small businesses. While the retention boost from removing tip taxes may not match Montana’s attrition spike, even a 50% reduction in turnover costs could save small businesses nearly $4,000 annually. These savings could help businesses reinvest, cover rising costs, or improve cash flow.
Restaurants may not benefit from eliminating taxes on tips
The largest share of tipped employees in our sample – 48% – work in the restaurant industry. However, we did not observe any increased probability that a restaurant employee would leave their job after Montana began taxing tips. One reason may be that restaurant employees tend to earn more than other tipped workers, even when tips are taxed. Restaurant tipping culture is well-established, unlike in some other industries. For example, tips account for 17% of the average total gross pay for tipped employees in Montana. Even after imposing a state income tax, many workers may still be financially better off keeping their current position.
The majority of employee attrition happened at companies that pay tips outside of the restaurant industry. Tips have been on the rise outside of full service restaurants in recent years. For example, small retailers may offer training courses on how to use purchased gear, have a snack bar inside the store, or provide other services for which customers are invited to tip. As labor costs increased, small businesses began using tips to supplement wages in order to compete for employees. In Montana, these positions would have been particularly attractive because it would have been untaxed income, and losing that advantage meant that these small businesses experienced greater attrition.
The hospitality and personal services sector has some of the highest attrition rates among tipped workers, further suggesting that tipped restaurant workers are unlikely to change jobs compared to other tipped employees. Tipped employees in the tourism, health care, and hospitality industries, all of which make up the hospitality and personal service sector, have estimated attrition rates of between 0.5% and 1.0% per month. Comparatively, tipped employees at restaurants have between 33% and 66% less of a chance of leaving their positions with an annualized monthly attrition rate of 0.36%.
This means that eliminating federal income taxes on tips may not increase the overall retention rate at restaurants even while it may help other tipped industries. Some cash tips already go untaxed among restaurant employees, reducing the impact of any policy change. Additionally, restaurant employees are already some of the least likely tipped employees to leave their position. Existing tip culture ensures that they’re able to predict their likely income, which may not be an option for similar non-tipped work.
However, if tips become exempt from federal income tax, employers who pay tips may see an influx in applicants for open positions. This may help restaurants fill open positions but could pull workers away from non-tipped industries, worsening labor shortages elsewhere.
Conclusion
Montana’s experience offers a rare case study on how tip taxation affects worker retention—but in reverse. While taxing tips led to higher turnover, eliminating tip taxes at the federal level is unlikely to produce a perfectly symmetrical retention boost. Even if small businesses see some cost savings, the broader effects of this policy remain uncertain. Some industries, like food service, may see little benefit, while others could experience real improvements in employee retention. At the same time, reducing turnover—especially in a tight labor market—could be a welcome relief for small businesses struggling to hire and retain workers.
Methodology
Estimating Montana attrition rates
Our sample includes tipped Montana employees from January 2023 to November 2024. Attrition was defined as an employee receiving pay in one month but not the next. Missing payroll periods were imputed and the employee was considered to not have worked or been paid in that month to ensure data continuity.
We employed a fixed effects panel regression model to isolate the relationship of the new tax on an employee’s likelihood to leave their job, controlling for total pay, business size, local unemployment rates, and employer characteristics. The key variable of interest was whether an employee received tips, interacted with the post-policy period. Results showed a significant increase in attrition among tipped employees, though restaurant workers exhibited no change, suggesting industry-specific differences.
Calculating cost of attrition for Montana businesses
The average Montana small business with tipped employees has eight tipped workers. To estimate the impact of the tax change, we assume an average business size of eight employees and an annualized 12% increase in attrition, leading to 0.96 additional departures per year. Using Gallup’s estimate that replacing a worker costs 26% of their annual wage, and based on our calculation that the average total annual income of tipped employees in Montana is $32,000, the per-employee replacement cost is $8,320. Multiplying this by the additional departures, we estimate that the average small business incurs approximately $8,000 in extra annual turnover costs due to this policy change.
