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In recent times the government has chosen to jump on the bandwagon of supposed ‘scandals’ regarding business practices. A couple of weeks ago it was the furore surrounding boarding passes and VAT at airports. In that debate, there seemed to be little understanding of the economics of such practices, as my colleague Philip Booth made clear. This weekend saw yet another example of such woolly thinking, with the government launching a consultation on the supposed scandal of tipping practices in restaurants. Apparently it is the role of government to investigate why “some restaurant chains are regularly holding back some or all of the tips meant for their staff”.

Quite simply, the approach to service charges and tip distribution should be nothing to do with the government. All restaurants operate in very different market places, have different approaches to attracting and maintaining staff, have different approaches to how to serve and distribute food, and therefore ultimately how to deal with tipping – explicitly pre-payment or after payment. The mistake of the government is to assume that this underlying economics doesn’t matter because the social convention and assumption is for the tip to be added to the bill to go directly to the waiting staff.

In order to think about this, it’s interesting to think about the economics of tipping from first principles. Why did tipping arise and how has it become a social norm? Tipping actually serves a useful function because it gets around a number of problems potentially associated with hiring salaried staff.

First, it dampens the financial risk of hiring. When an employer hires a new member of staff, particularly for relatively low skilled jobs where often we are talking about new labour market entrants, employers may have little insight as to how well the employee would perform. A lower fixed wage with more of the compensation dependent on performance thus relieves employer risk – through both encouraging the employee to perform better and lowering the fixed cost to the firm.

For similar reasons it also overcomes informational asymmetries. It is difficult for a restaurant owner to really know both what the customer wants from a waiter and how that waiter interacts with customers given waiters’ differing personalities and other character traits. Without the information for the employer to set appropriate wages for each member of staff given the value to the firm, tipping can help provide differential remuneration for staff members – with customers having and providing much better information. Tips also align the incentives of employee and employer in terms of delivering customer satisfaction.

But this sort of analysis of the economics of tipping also highlights why some restaurants might want to decide to pursue different strategies outside of the social norm. It might be, for example, that in a certain small restaurant or chain with established practices, the desires of customers and the performance of staff are much more readily observable. It therefore might make more sense to have fixed pay for employees and absorb the social norm of the ‘service charge’ into general company revenues. They may believe that this happens to be better for staff morale or retention. In other restaurants, you don’t have an established waiter for each table, and so it makes sense to either pool tips or simply to absorb the norm into revenues again. If it is not obvious which aspect of the restaurant experience has encouraged a generous service charge, then this may be better for staff morale too.

Now, it may be that the staff think in some instances that the company is not passing on rewards for overall good performance and therefore ‘taking advantage’ of all staff. But there are already market processes to deal with these issues. The business may gain a reputation for being an unfair place to work – affecting the quality of potential new hires. The workers can get together to seek to negotiate a greater share of the spoils. Customers likewise may seek to enforce the tipping social norm by raising the issue in public, causing the businesses to change their business practices accordingly.

There are so many things that restaurants have to consider when considering their company policy on tipping that contemplating imposing some form of strait jacket such that firms can only maintain a certain proportion of tips for generalized revenues is something that makes no sense. How on earth would this be enforced? How does one assess whether or not the tipping gains are passed on already? Has nobody thought that it would simply lead to many adjusting pricing and remuneration policies accordingly? If a restaurant gets regularly high tips now, then what if it has already in effect rewarded staff for this through higher salaries? Enforcing a new ‘proportion of tips’ rule could then just actually lower fixed pay for staff, which may be a less appropriate model for the business.

It’s unclear to me then why the Conservatives have jumped on this cause. Perhaps it’s an overtly political move – to co-opt these types of campaigns which purport to be ‘pro-worker’. The Conservatives are trying to rebrand themselves as the Worker’s Party after all. Perhaps it is simply that business minister Sajid Javid, who has a remarkable back story from a working class background, considers this an issue of common decency – for restaurants to be transparent that service charges are actually rewards for service.

Social norms and trust are indeed important in market economies. But social norms arise from the bottom up and attempting to impose them by law can have unforeseen consequences. In fact, one wonders whether this whole ‘clamp down’ is an attempt to stop restaurants adjusting for the increased fixed costs associated with the government’s own National Living Wage policy. Whatever the reasoning, it’s another incidence of poor economic analysis at play.

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As in all IEA publications, the views expressed in this blog are those of the authors and not those of the Institute (which has no corporate view), its managing trustees, Academic Advisory Council or senior staff.

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