Overtime Income Tax Break: Not Illogical, Just Costly and Complicated
Alex Brill, Kyle Pomerleau and Stan Veuger | AEIdeas
Last month, former President Donald Trump declared, “If you’re an overtime worker, when you’re past 40 hours a week . . . your overtime hours will be tax-free.” If kept, this promise, though as vague as many of the proposals coming from the Trump campaign, risks creating compliance and administrative burdens, not to mention significantly reducing revenue. However, there is also notable logic behind the proposal.
First, the good news. There is clear theoretical logic to exempting overtime income from taxation based on well-recognized principles from the optimal tax literature. A common argument in this literature, including in James Mirrlees’s seminal 1971 paper, is that the optimal income tax system would tax people based on their ability, their earnings potential. In practice, tax is imposed on realized earnings, which is a function of both ability and effort, since ability and effort are generally not separately observable by the government. As a result, the tax code distorts work decisions by penalizing effort and imposes the same tax rate on both a worker with low ability and high effort and a high-ability, low-effort worker with the same total income.
Because overtime hours are a reasonable proxy for effort, exempting overtime pay from taxation could be a more efficient way to encourage work than a broader income tax cut that increases the returns to both ability and effort.
Although some have criticized the fairness of such an exemption, one could also defend Trump’s proposal in more explicit equity terms. If there are two workers with identical incomes but one works 60 hours a week and the other works 40, it may be seen as fair to tax the former worker less than the latter worker. After all, the worker putting in 40 hours a week is otherwise better off, with more leisure time at their disposal.
Now the bad news. First, defining “overtime” may be tricky. The Fair Labor Standards Act (FLSA) defines overtime as time worked for an employer in excess of 40 hours in a week and requires employers to pay one and a half the regular rate of pay for overtime hours. However, these rules do not apply to certain occupations and types of work. For example, administrative workers, computer programmers, various “learned professionals” (accountants, engineers, and teachers, for example), and “creative professionals” (actors, musicians and writers, for example) who are paid a weekly salary above a set threshold ($1,128 per week starting January 1, 2025) are generally exempt. Tracking overtime for workers that currently do not may be administratively burdensome and vulnerable to gaming.
Second, an overtime exemption could have a significant impact on the budget deficit depending on its structure. If we assume FLSA overtime pay (both the wage plus the overtime premium) were an exclusion from gross income, this proposal would reduce federal income tax revenue by $812 billion from 2025 to 2034. In contrast, if FLSA overtime pay were an allowable deduction from taxable income, it would reduce income tax revenue by $382 billion over the same period. The difference in cost is due to how these approaches interact with other income tax provisions. In this specific case, a deduction against taxable income would result in more taxpayers facing the alternative minimum tax, clawing back more than half of the benefit.
If FLSA overtime income were also exempted from payroll taxes, the cost would rise by an additional $413 billion. Although this would increase the benefit for workers who earn overtime, it would come at a cost of reduced future Social Security benefits and would accelerate the Social Security trust fund’s insolvency.
Third, overtime is not a perfect proxy for effort. An individual who works two part-time jobs, each for 30 hours a week, would not receive this tax cut. Depending on design, the tax cut on overtime may not be available to individuals who work more than 40 hours but do not qualify for FLSA overtime protections. It would likely be unavailable to self-employed workers, for example, and therefore distort the decision to choose employment over self-employment.
Finally, earnings potential is at least partly endogenous. Taxing it distorts the decision to accumulate human capital or to make risky career choices. This consideration is not part of the basic Mirrlees framework, where earnings potential is exogenous and, as a result, earnings potential and effort, however broadly defined, are fully separable.
While an overtime exemption has some theoretical justification, it’s not clear it’s worth it. Lawmakers already face a significant federal budget deficit that will climb to roughly seven percent of GDP by the end of the decade. That’s even before considering the high likelihood that lawmakers extend the Tax Cuts and Jobs Act individual income tax cuts in 2025. Lawmakers should focus on addressing this before adding to the already long list of new tax cuts.
Read here. Find other articles about the presidential election here and here.
