“No Tax on Overtime” Raises Questions about Policy Design, Equity, and Tax Avoidance

Most people when they talk about “overtime” mean any job where someone works more than 40 hours a week. While this can be useful shorthand, in practice US overtime regulations are more complex. Not all workers are eligible for overtime, and the rules apply differently to hourly and salaried employees.

The Fair Labor Standards Act (FSLA) generally requires that employers pay eligible employees 1.5 times their regular rate of pay for time worked over 40 hours in a given week. The FSLA does not apply to certain occupations like the military and the clergy to begin with, and it only covers employees, not the self-employed and independent contractors. The FSLA also explicitly excludes from overtime coverage certain employees in specific named occupations, such as lawyers, outside salespersons and teachers, regardless of whether they are hourly or salaried employees. The FLSA also includes what is commonly referred to as the “white-collar” exemption, which goes beyond specific named occupations and broadly excludes employees engaged in bona fide executive, administrative, or professional capacities from overtime protections.¹

According to the Department of Labor, in 2023, there were 97.7 million employed workers who were eligible for overtime protections under the FLSA. That was 60% of household employment that year and about 2/3 of wage & salary employment.² Among these, 82.1 million were hourly workers and 15.6 million were salaried workers. These workers are in a range of occupations and can be found across the income distribution.

But being eligible for FLSA is different from actually working overtime in practice. Roughly 8% of hourly workers and 4% of salaried workers work FSLA-qualified overtime on a regular basis (see figure below). An additional 4% of hourly workers and 1% of salaried workers do so occasionally; i.e. they usually do not work more than 40 hours but were recorded in the Current Population Survey (CPS) as actually working over 40 hours in the reference week. Meanwhile, about 7% of hourly workers and 70% of salaried workers do not qualify for FSLA in the first place. 

There are two important considerations for understanding how exempting overtime pay from tax would work.

The first is about policy design: how would the tax break be structured? Presumably, eligibility would be tied to the FLSA overtime eligibility, as outlined above. Other design questions include:

• Would the exemption apply to income tax only, or also payroll tax? As discussed in previous Budget Lab reports on tipped income, all workers owe payroll tax, but some workers do not earn enough to pay income tax. Therefore, relative to an exemption for both income and payroll tax, a policy design which applied only to income tax would result in a lower budget cost but limit benefits for lower-income workers. A payroll tax exemption would also potentially reduce eligible workers’ future Social Security benefits, which are tied to a worker’s reported earnings.
• Would the exemption apply only to the bonus portion of overtime, or all income earned through overtime? In other words, if overtime pay is 1.5 times the regular rate of pay, is only the extra 50 percent tax-free, or is the entire amount tax-free? In our budget estimates below, we assume the latter policy design. 

The second consideration is administration: how would employers and employees report the relevant information to the IRS? Under current law, there are no line items on IRS Forms W-2 or 1040 which distinguish regular pay from overtime pay. The IRS would have to require that the employer report this information and add additional lines to allow for separate calculations of tax depending on the type of pay. While employers with overtime-eligible workers already compile this information to comply with FLSA regulations, the addition of new reporting requirements and line items complicate tax filing for both employers and employees, leading to an increase in the time burden of tax filing. However, as noted in previous work, some of these filers are candidates for pre-filled returns and would remain so if this proposal was enacted. 

As described above, there is no information on overtime pay in any tax data source. We impute FLSA-qualified pay in our tax microsimulation model by estimating the statistical relationship between overtime, wages, and demographics using CPS data. Please refer to the Methodology section below for further details and model code.

On a static basis—that is, before considering any behavioral feedback—our model makes four key projections:

• FLSA-qualified overtime pay among tax filers—accounting for both the base wage above 40 hours plus the wage premium—will total $335 billion in 2025—about 3% of total wages reported on tax returns and 1.1% of GDP.³
• This income will face an average effective income tax rate of 19% in 2025 and about 22% after the scheduled expiration of TCJA’s individual tax cuts, starting in 2026.
• An above-the-line tax deduction for overtime pay would cost an estimated $866 billion over the 2025-2034 budget window, before considering any behavioral feedback effect.
• If this exemption also extended to payroll taxes, this static cost estimate rises to more than $1.3 trillion, before considering any behavioral feedback effects. About 77% of the foregone payroll tax revenue is revenue that would have been dedicated to Social Security.⁴

A key principle of tax policy is that taxpayers with equal incomes should pay similar amounts in taxes. It is useful to evaluate new tax proposals through a horizontal equity lens—that is, to consider whether the new proposal would create greater divergence in how similarly situated tax filers would be treated under the code.

Exempting overtime pay from taxes would exacerbate horizontal inequity, arbitrarily favoring certain workers over others. Consider two examples based on potential wages and likely overtime eligibility for a few occupations:

• Consider a hotel clerk who makes $16/hr and works 45 hours a week, earning about $760/wk (~$39,500 annually) with their overtime pay. Compare this worker to a clerk at a car rental business who earns $19/hr and works 40 hours a week, making roughly $760/wk (~$39,500 annually). Under a tax preference for overtime, the hotel clerk would have a lower tax burden than the car rental clerk despite them both workers earning the same amount each year.
• Similarly, consider a front-line supervisor at a retail store who works 50 hours a week earning about $1,250/wk (~$65,000 annually). Because this worker falls within the “white collar” exemption and is not eligible for overtime pay under the FLSA, they would not benefit from the “no tax on overtime” proposal. Meanwhile, a medical records technician who falls outside of the “white collar” exemption earns just under $23/hr and typically works 50 hours a week. With her overtime pay she is also earning about $1,250/wk (~$65,000 annually). Under a “no tax on overtime” policy, while these two workers earn the same amount each year, the medical records technician wouldn’t have to pay taxes on more than $17,700 of their earnings while the retail worker would continue paying taxes on their full salary of $65,000.

Tax proposals that favor one form of income over others create opportunities for tax avoidance. Under this proposal, there is an incentive for both salaried, overtime exempt workers and their employers to adjust their employment and pay arrangements to improve their outcomes. Whether employees or employers will be able to achieve these outcomes will of course depend in part on their relative bargaining power. Consider two examples at either end of the spectrum.

At one end, an employer with greater bargaining power could reduce the amount of compensation they pay their employees (while not lowering the workers’ after-tax or “take home” pay). Take for example, a general operations manager who is currently overtime exempt and makes roughly $160,000 per year, consistently clocking 50 hours a week (with an implied hourly rate of roughly $62/hr). Let’s assume they face a 20% average tax rate, meaning their take-home pay is currently $128,000. Under the proposal, their employer could switch this employee to an hourly worker, pay them just over $52/hr, and still schedule them to work 50 hours per week. This would reduce the compensation paid by the employer to about $150,000. But since the employee would no longer be paying taxes on the $40,560 they earned in overtime pay (at $78/hr), their take-home pay would still be the same at roughly $128,000. In short, under some circumstances employers may leverage their bargaining power over employees to use a no tax on overtime proposal to reduce their labor costs without the employee ever seeing any reduction in after-tax pay or any tax benefit from the proposal.

At the other end, employees with significant leverage may be able to restructure their pay so that they significantly reduce their tax liabilities, as Heidi Shierholz suggested in this piece. A salaried CEO, for example, that makes $10,000,000 per year could agree to work 50 hours per week with the first 40 hours paid at $3,500 per hour and the remaining 10 hours at $5,250 per hour and make the same compensation. In this scenario, the overtime pay of $2,730,000 would not face income tax. In this scenario, the employee is better off, and the employer is no worse off.