OBBBA’s new rules for the Supplemental Nutrition Assistance Program (SNAP) begin taking effect next year, when administrative cost reimbursements are reduced. For Medicaid, Congress punted the effective date to 2027 so that the pain would not be visible prior to the 2026 midterm elections, but expensive state-level information technology system changes will be needed next year to be ready for the new statutory qualifications requirements.
The added annual cost for counties alone is estimated to be $850 million. Their national association puts the total cost of OBBBA for “subnational governments” at $1 trillion over 10 years, including the cost-shifting for benefits payouts as well as administrative expenses. The states’ new, unreimbursed transitional administrative costs are likely to exceed $1 billion a year, although there is no single source of such data to date, only a handful of single-state ballpark guesstimates.
Although provisions relating to social services generated the most angst as the new law made its way through the congressional sausage grinder, there’s another that got far less attention outside of the labor law community, and it relates to the taxation of overtime work. The big bait-and-switch surprise for workers and employers is that the new tax law falls far short of what everybody thinks was promised in the president’s campaign pledge to make overtime pay tax-free.
At most, workers will likely enjoy a federal income tax deduction for only a third of what they are actually paid for overtime work — or even less. Social Security, Medicare and state income taxes will still apply to all pay. And payroll departments nationwide have a huge headache ahead of themselves to make, distribute and explain the W-2 calculations next January. This whole vote-grubbing idea was bad tax policy to begin with, but Congress has made it a desk work nightmare for public employers in particular. The cost of installing and feeding records into patched payroll software will be megamillions nationwide — costs borne by every employer in the public sector.
But public employers (not to mention union leaders) also will face the challenge of explaining to their workers why their overtime tax break isn’t as big or beautiful as they were expecting to see on those 2025 W-2s. What ended up in the OBBBA is in reality a limited tax deduction that only applies to some workers. Two-thirds or more of the overtime payments to public employees under union contracts, state laws or local personnel policies will be ineligible for the new federal tax deduction.
Here’s why: The OBBBA tax deduction cuts off at the federal Fair Labor Standards Act (FLSA) methodology to determine overtime eligibility, which typically requires overtime pay only when a non-exempt employee actually works more than 40 hours in a workweek. OBBBA does not allow overtime tax deductions unless FLSA requires an overtime premium, and then it’s only the premium portion (just the “half” of time-and-a-half). Paid time off does not count as working hours. FLSA does not require premium overtime cash payments for weeks when the employee takes a paid holiday, vacation leave or sick leave on some days and then works a few extra hours on other days.
Congress jammed a square peg inside a round hole when it wrote these overtime provisions, leaving big legal gaps of nondeductible pay. Thus, the FLSA compensation minimum looks to become the IRS maximum for this overtime tax deduction. Congress did not explicitly authorize the new federal tax deduction for workers whose employers count paid leave in their overtime calculations — as do most states and municipalities — and therein lies the problem, one that falls heaviest on public employers with generous paid leave policies.
Almost all states and localities pay more than the FLSA minimum in their overtime policies. Adding to the confusion, there are also special rules for state and local governments contained in federal labor law, which may or may not apply when calculating OBBBA-eligible deductible overtime — there’s still some gray area on that.
Manual Workarounds by the Millions
Opinions are still unsettled in the public finance community as to what all this means. But some things are already clear, and they’re not pretty. For many local governments in particular, some of the 2025 W-2 tax reporting process will require manual calculations at the per-employee level, if the OBBBA statute is followed literally and employers’ hourly time reporting systems are non-conforming. About half of U.S. workers put in some amount of overtime in a given year, so even if it’s only a quarter of the more than 20 million state and local employees, that means 5 million personalized individual tax calculations might be needed for 2025.
For those public employers fortunate and sophisticated enough to already use completely digital timekeeping — payroll input and processing systems that collect “e-timesheets” and categorize all pay in terms of hours actually worked, along with holidays, vacation and sick leave, and FLSA-mandated overtime hours — the OBBBA-compliant process for calculating the new W-2 documents next January should simply require a software patch. For everybody else, there’s a much worse recordkeeping nightmare ahead.
Most public employers grant time off for holidays, personal leave and vacations, and pay overtime on the extra hours that include their paid leave in the payroll workweek. Double-time payments are never required under FLSA, thus are mostly ineligible for the new tax deduction. Likewise, some public employers with 35-hour workweeks (common in parts of New Jersey, for example) often pay an overtime premium for time worked over that number and not the 40-hour federal threshold. Union contracts and internal personnel policies govern the overtime clock practices of these employers, as long as they meet or exceed the minimum standard of FLSA — and most are more generous under their own rules and labor contracts. But that magnanimity gets no credit on their OBBBA W-2 tax forms.
Here’s a good illustration: This coming Thanksgiving weekend, a patrol officer earning a salary of $83,200 ($40 an hour) works four regular eight-hour shifts, gets the holiday off, and then earns 10 hours of double-time pay that Saturday directing traffic on crowded roads near the local shopping mall. Her federal tax deduction will be $40, not $800 as most people would expect. And if she instead works that weekend double-time traffic duty a day later on Sunday (in the next workweek), her tax deduction for that day would most likely be $200. That’s how misrepresented, complicated and misunderstood the new tax law is for most public employees when it comes to their new overtime tax deduction. Confusion is certain to abound.
If you are wondering why public employers shouldn’t just cut corners and report as much overtime on the W-2s as their employees are actually paid, it’s because they are all subject to independent public audits that would get everybody penalized once the violations are disclosed as the auditors must.
Needed: Unambiguous Regulations
For now, the best thing to tell affected employees is that this OBBBA-FLSA overtime mess is complicated and that it’s too soon to know exactly what they can deduct on their 1040s until the IRS issues final regulations later this year. So they should reduce their expectations of what they will be able to deduct for 2025.
Until the IRS and the Treasury Department release some transition rules for employers to follow, probably sometime in September, it’s important to not jump to conclusions; the foregoing analysis could still be subject to change or exceptions when those regulations are finalized.
Treasury could do everybody a big favor by providing some simple clarifying examples and clear safe harbors that define what’s a reasonable approach to solving this Rubik’s Cube problem, by adjusting for paid leave in the simplest ways possible. Something like a de minimis provision also would simplify everything for those workers whose total gross overtime is less than $500 this year, where the employers’ senseless cost of data-digging would exceed the IRS tax loss even if all overtime pay for that worker could be W-2 deductible.
To avoid confusion when W-2 forms are delivered next January, the IRS should provide explicit, plain-English guidance and examples that employers can cite to workers on what portion of overtime pay is tax deductible, and should illustrate exactly how employers should treat paid time off in the weekly calculation of “actual” worktime in the tax deduction context.
It’s probably hopeless to now expect Congress to reimburse states and localities for all or even most of these added administrative burdens, and only the lawmakers under the Capitol dome can fix their burdensome new SNAP and Medicaid rules. But the IRS can help public employers by making it clear just which payments of overtime will qualify for the new tax deduction, at what rate, and which won’t. (For a timely update on what’s on the minds of the experts, here’s a link for an upcoming Government Finance Officers Association OBBBA webinar.) Nobody wants the new law to invite abusive practices, so whatever is done hereafter should be more mindful of the costs to taxpayers at all levels of government.
Governing's opinion columns reflect the views of their authors and not necessarily those of Governing's editors or management. Nothing herein should be construed as tax advice.
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