Alabama Expands Tax-Free Overtime Eligibility, but Should Repeal Entire Exemption

Before President-elect Donald Trump proposed it at the federal level, Alabama passed a law exempting overtime wages from taxes back in November 2023. Act 2023-421 (H.B. 217) excluded any amounts received by a full-time, hourly wage employee as compensation for work performed above 40 hours a week from state income taxes, starting January 1, 2024.

While similar measures were proposed by North Carolina and South Carolina earlier, Alabama is the first and so far only state to adopt an overtime exemption, which was intended to compensate lower-income wage earners for inflationInflation is when the general price of goods and services increases across the economy, reducing the purchasing power of a currency and the value of certain assets. The same paycheck covers less goods, services, and bills. It is sometimes referred to as a "hidden tax," as it leaves taxpayers less well-off due to higher costs and "bracket creep," while increasing the government's spending power. and the COVID shutdown-induced income losses. In a recently passed amendment, the state legislature expanded eligibility to some full-time salaried workers who qualify for overtime pay under the Fair Labor Standards Act (FLSA) as well, effective October 1, 2024. The US Department of Labor has announced that the FLSA threshold under which one is eligible for overtime pay, starting July 1, 2024, is $43,888, a figure that will increase to $58,656 from January 2025. Now Alabama's full-time workers who make less than these figures would benefit if they work more than 40 hours in any week.

The amendment, Act 2024-437: U.S. Fair Labor Standards Alignment, puts to rest the confusion about what exactly is exempt from Alabama's income taxes. Advocates for some hourly workers previously claimed that commissions, incentives, and bonuses paid above and over 40-hour wages to an hourly worker would qualify. The new amendment aligns the state exemption definition of "overtime" to the FLSA's definition, as the state's answer to such questions and uncertainty. With this change, the exempt overtime pay will now be based on the employee's overtime computed in accordance with the FLSA. Now, roughly 1.1 million workers in the state would be covered by this exemption, which would be administered based on monthly or quarterly filings by employers delineating base and overtime wages for each worker, as directed by the Alabama Department of Labor.

The FLSA provides federal overtime regulations that all states, including Alabama, must follow. Federal law dictates that unless the employee in question is exempt, all hours worked over 40 within a week must be paid at a rate equal to at least one and a half times the regular pay rate. Some employers choose to supplement that with holiday pay as applicable. In Alabama, all that extra pay is now taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. -free, at least until June 2025, when the measure is scheduled to sunset.

Of course, the state legislature may choose to extend the exemption beyond that date, but allowing it to expire is probably the best idea. Lower taxes, especially for lower-income wage earners, may sound good, but such arbitrary income tax exemptions only increase compliance costs and introduce distortions into the labor market. They create an incentive for employees to look for hourly or non-exempt jobs, and existing employees who qualify for overtime would seek more hours.

Additional overtime hours for existing employees could crowd out the hiring of additional employees, either by making overtime labor cheaper (employers could potentially pay less) or by increasing the return on the marginal labor (because it is untaxed). And employers may be pressed to adjust policies on overtime, or may find themselves in the position of needing to limit it. Time and effort would be wasted on negotiating employment agreements instead of being put to productive use. While some employees do indeed benefit from this law, which, in theory, should also lead to a small increase in labor supply (from existing employees), the resources wasted on compliance and induced inefficiency detract from these gains. A better way to achieve the same positive supply shock would be to decrease the overall income tax rate and do away with all such distortionary and arbitrary exemptions.

At present, the policy penalizes workers who earn a salary marginally above the overtime threshold or are not otherwise able to work overtime. Retail and the services sector workers, for example, receive a tax break, while workers in an office environment with fixed schedules continue to be subject to higher average income tax rates for no fault of their own, and without a good policy justification. A good tax system should be neutral, not favoring one sector over another.

Tax reform in Alabama is desirable and very possible. However, the overtime exemption, which complicates the tax code, reduces neutrality, and adds to compliance and reporting costs, is not a good example. Lawmakers would be wise to let it expire this coming June.