Exempting overtime pay from state income tax was a new idea that caught on quickly at the Alabama State House in 2023.

The Republican majority threw their support behind the proposal by House Minority Leader Anthony Daniels, D-Huntsville. Not a single lawmaker in either party voted against the bill.

Gov. Kay Ivey held a ceremonial bill signing at the Hyundai auto plant in Montgomery, joined by business leaders and legislators from both parties.

President-elect Donald Trump has since proposed a federal tax exemption on overtime pay.

Now a new report estimates the fiscal impact of Alabama’s overtime tax exemption was $230 million during the first nine months of 2024, far more than expected.

That’s money that would have gone to the Education Trust Fund. Income taxes are the largest source of money for public education in Alabama.

The prospect of losing school funding leaves lawmakers with a decision on whether to keep the popular tax exemption.

“It’s a whopper,” said Sen. Arthur Orr, R-Decatur, who chairs the Senate’s education budget committee.

‘Workers take home more money’

The exemption is scheduled to expire on June 30, 2025, unless the Legislature extends it. Lawmakers added the expiration date because of uncertainty about how school revenues would be affected.

They also required the Alabama Department of Revenue to collect information on overtime pay from employers.

It was the ADOR report that estimated the impact of $230 million from January through September this year.

Daniels, the sponsor of the overtime bill, acknowledges that the $230 million in exempted tax payments was more than expected. Daniels said he does not think the amount justifies allowing the exemption to expire.

“The legislative intent was to increase workforce participation and help hourly workers take home more money without requiring their employer to do it,” Daniels said.

Daniels cites numbers from the U.S. Department of Labor that show 43,000 more people are working in Alabama than 12 months ago.

That includes jobs in manufacturing, transportation, utilities, education, healthcare, and other sectors. Daniels said that means more people are paying the state’s income tax, which has a top rate of 5%.

“If you do the math on that, and the average salary is $60,000, then you talk about 5% of 60,000 times 43,000,” Daniels said. “Those dollars go to what? The Education Trust Fund.”

‘Federal money is drying up’

While the employment numbers and Alabama’s labor force participation rate have increased this year, revenues that support the Education Trust Fund have leveled off.

That leveling off comes after a temporary surge fueled by the billions in federal dollars that Congress sent to the state in pandemic relief funds.

“We’re flat, more or less,” Orr said.

“The federal money is drying up. School systems have lost the federal money that they’ve gotten. So they’re scrounging to pay for a lot of the services and personnel that they brought to bear using the federal COVID money. In other words, they’re back on their own with the state dollars.”

Still, Daniels said it would be premature to let the overtime exemption expire.

Daniels said he will propose a bill that would extend the by another year and that would authorize a study to analyze the overall economic impact of the exemption.

Daniels noted that hourly workers who take home more money because of the overtime tax exemption will spend that extra money on products that carry state and local sales taxes, generally a total of 9-10%, money that helps fund state and local government.

“It’s rewarding hard work, giving them more of their tax dollars. And in return, they’re spending those tax dollars in different areas and it’s yielding the returns that we need,“ Daniels said.

Orr says that even assuming that employees spent all of their extra income from the exemption on taxable goods, that would still only return 4%, the state portion of the sales tax, or 3%, the state sales tax on food, to the ETF.

“A fair amount would go also to services that are not taxed or put in a church offering plate, or whatever, not spent on goods,” Orr said. “So it’s not a lot of money back through sales tax.”

What will lawmakers do?

Orr said legislators have to choose from a few options on what to do with the overtime tax exemption.

“You cap it. You let it expire and that’s it. Or we’ve got to make other provisions to try to replace the revenue if this is something that the Legislature wants to continue on full bore without a cap,” Orr said.

The overtime exemption applies to full-time, hourly workers. They do not pay the state income tax, which has a rate of up to 5%, on pay received for working more than 40 hours in a week.

Daniels advocated for the bill as a way to allow workers to take home more of their paychecks and provide an incentive that would help employers fill jobs and increase production at a time when Alabama is struggling with a low workforce participation rate.

“I thought at the time it was a unique idea, a good idea to reward those working hard,” Orr said.

“The hourly employees are not going to be your super wealthy individuals, and we wanted to give them some tax relief and support. So it seemed like a very reasonable idea. And it still does. It’s just the cost has turned out to be a lot more than was anticipated.”

In the last couple of years, Alabama’s state budgets were better able to absorb tax cuts and exemptions because of the unusual growth in revenue and the federal dollars for pandemic relief.

Besides the overtime tax exemption, the Legislature cut the state sales tax on food from 4 percent to 3 percent effective September 2023.

The tax on food would have gone down another penny this year, to 2 percent, but that did not happen because growth to the Education Trust Fund failed to reach a target of 3.5%. Lawmakers added that provision to the grocery tax cut to protect ETF revenues.

Orr noted that the ETF would be more likely to hit the 3.5% growth target and reduce the food tax if the overtime tax exemption is allowed to expire next year.

“So that may be a little incentive for the Legislature to let it expire,” Orr said. “I don’t know how that will play out.”

At least $100 million for school choice

The overtime tax exemption and the grocery tax cuts are not the only new initiatives that will affect public school funding.

Earlier this year, lawmakers passed the CHOOSE Act, which will allow parents to use up to $7,000 in tax dollars per child to pay private school tuition, or up to $2,000 for home school.

The program has income limits the first two years but is scheduled to be available to all families starting in 2027-28.

Lawmakers will allocate at least $100 million a year from the ETF to fund the CHOOSE Act, a priority for Republican lawmakers that Democrats said would hurt public schools.

Daniels said he would like to see the same scrutiny applied to all major initiatives that he wants to see with the analysis of the overtime tax exemption.

“Things that have been made permanent, there should have been a sunset provision with a study attached to it as well,” Daniels said.

“That’s how you become more fiscally responsible and learn from the decisions you’ve made. It’s not that you made the wrong decision, but you want to have an understanding of the full impact of it.”