Lindsay Tedds is an Assistant Professor of economics in the School of Public Administration at the University of Victoria. You can follow her on twitter @LindsayTedds
A recent CRA audit of income earned by 145 wait staff in St. Catharines, Ont., revealed $1.7-million in unreported tips and gratuities. On average, this amounts to $12,000 in unreported income per person audited and the audit uncovered that wait staff were only reporting between zero and 10 per cent of their tip income. In addition, it was found that tip income typically amounted to between 100 and 200 per cent of wage income. That is, wait staff earn up to double their wage income in tips.
These figures call into question Statistics Canada's recent $36-billion estimate of the Canadian underground economy. The estimate included income from undeclared tips by assuming that tips amounted to only 50 per cent of wage income ($3-billion in 2008) and, of that, only half was unreported. These assumptions led Statistics Canada to estimate that undeclared income from tips by wait staff amounted to $750-million.
Given the results from CRAs audit, we now know that Statistics Canada grossly underestimated the contribution of unreported tips to the underground economy. Using the audits facts that tips amounted to 100-200 per cent of wage income (though it can be as high as 400 per cent), and that a full 90-100 per cent was unreported, this leads to an estimate of undeclared income from tips for 2008 of between $2.7- to $6-billion, significantly higher than the $750-million assumed by Statistics Canada.
If this income was taxable at the lowest marginal bracket of 15 per cent then this translates into $405- to $900-million in lost tax revenues at the federal level alone, not including any overpayments of tax benefits and credits. While some may not think this is a lot of money, this is lost tax revenue from just wait staff, and assuming the lowest statutory tax rate. Many other service staff earn money from tips (e.g., salon and spa staff, taxi drivers, hotel staff) which means the tax revenues lost from unreported tips is likely quite substantial.
What can be done about bridging this tax gap? A simple solution is to build on the method that CRA used to uncover the unreported tip income and subject tip income to third-party reporting. This was nearly impossible to do in the past, but with modern day point-of-sale systems and the simple paper trail left by credit cards, most tip income could easily be included in T4 reported income. In fact, all businesses must already report "controlled" tips (when a service charge is automatically charged to a bill which many restaurants do for parties over a certain size) in T4 income. Subjecting tip income to third-party reporting would revoke much of the control that staff earning tip income have over their compliance decision and eliminate the tax preference they obtain by being able to under-report their income.
While such a change to the reporting of tip income won't completely eliminate the under-reporting of tips (including cash tips and any transactions eliminated from record using a zapping device), it will go a long way towards recovering evaded tax income. There is also an unexpected benefit from subjecting tips to third-party reporting. Benefits under the Canada Pension Plan are tied to reported income so an increase in reported income means that these staffers will benefit from higher pension benefits in their future.
The CRA audit also reminds us how important it is to properly educate people about the tax system, their tax obligations, and penalties for under-reporting income. The audit uncovered that employees were being told that they only need to report 10 per cent of their wages as tip income. This is an interesting urban legend that should have been quickly questioned by any one with even a cursory understanding of the tax system.
Those wait staff who under-report their tips might also be very surprised by the penalties of not reporting. Penalties start at 10 per cent of the amount that was not reported, plus interest. In addition to this, you can be hit with a 20 per cent "repeated failure to report income" penalty if you don't report income twice or more within a four-year period. You can also be assessed a penalty of up to 50 per cent of the understatement of tax for giving a false statement. Finally, you can go to jail.
What can you do if you have earned income from tips and have failed to properly report this income? You should educate yourself about CRAs Voluntary Disclosure Program. If you make a full disclosure before any compliance action is started, you may only have to pay the taxes owing plus interest, but not the penalties. Waiting for CRA to contact you can be an expensive proposition.