The economics of tips

Tipping is a widespread practice in the United States that continues to grow, yet the economic implications of this custom remain largely unexplored. By analyzing point-of-sale and payroll data from over 20,000 U.S. firms, researchers have gained valuable insights into the relationship between tips, worker earnings, and firm profitability.

The findings reveal that tips constitute nearly a constant share of revenue for these companies. Consequently, hourly wages for employees are closely tied to the overall revenue of the firm. When firms start collecting tips, they typically reduce their base wages by a significant amount, ranging from 23 to 33 cents for every dollar of tips received.

One of the key advantages of tipping is its ability to reward worker effort. Employees at tipping firms tend to earn higher incomes as they serve more customers. This connection between tips and productivity was demonstrated through the use of demand shocks derived from customer spending at other businesses. When a demand shock occurs, it leads to a nearly double increase in revenue for tipping firms compared to non-tipping establishments, while base wages and prices remain unchanged.

The impact of tips on firm output per hour is also noteworthy. Despite a larger increase in working hours, firms with tipping employees experience a greater boost in productivity per hour worked. This is primarily due to the fact that each worker becomes more efficient, allowing the firm to expand and recover approximately one-third of the earned tips.

However, not all firms adopt the tipping system. The level of customer tipping plays a crucial role in determining whether a firm decides to implement it, with the benefits being smaller in industries where customers tip less frequently.

To better understand the potential gains from tipping, researchers developed a model that was calibrated using the demand-shock estimates. According to this model, firms that experience higher customer tipping rates see a significant boost in job value, estimated at around half, and a 30% increase in firm profit. These positive outcomes may contribute to the recent trend of tipping becoming more prevalent across various industries.

The research conducted by Dylan Balla-Elliott and Isaac Norwich, with Isaac set to join the job market this year from the University of Chicago, sheds light on the economics of tips, providing valuable insights into the relationship between tipping practices, worker productivity, and firm profitability.