Markets on Main

Markets on Main

What the new overtime rules mean for you and your boss

Obama’s speech announcing his new overtime rules emphasized their impact on economic growth. Larry Downing/Reuters

Earlier this month, the Department of Labor outlined changes to the existing overtime exemptions.

As you are probably aware, some employees are exempt from being paid overtime, meaning their employers don’t have to pay them extra when they work over 40 hours in a week. The Fair Labor Standards Act outlines the criteria for this exemption.

Employees currently qualify for exempt status by clearing two hurdles: 1) the duties test (position is executive, administrative or professional) and 2) the salary test (worker earns at least US$455 a week or $23,660 a year).

The new rules, set to take effect on December 1, change the height of the hurdle for the salary test but do not alter the duties test. The new threshold will be $913 a week ($47,476 a year), or 40 percent of the average full-time salary in the lowest-wage census region (currently the South).

So the headline of all this is that some employees (estimated at 4.2 million) who are currently exempt from overtime because they earn at least $23,660 (but less than $47,476) will no longer be exempt.

Is this a win for workers? And a loss for employers? In truth, the real impact on both groups and the economy is much more nuanced.

What this means for an employer

To illustrate this, let’s imagine that a company employs Dennis as a lab technician.

Dennis currently earns $42,000 a year and regularly puts in 50 hours per week in the lab. The company doesn’t pay overtime for anything over 40 hours per week because he is exempt from overtime pay. He meets the following requirements: he passes the salary test by earning at least $455 a week and the duties test because he is a “professional” employee. That is, his primary duty requires advanced knowledge, in the field of science and acquired by a prolonged course of specialized intellectual instruction.

But on December 1, Dennis would no longer clear the salary hurdle. So what’s his employer to do?

The company has the following main options:

  1. increase Dennis’ salary to $47,476 and keep him as an exempt employee,

  2. make him a non-exempt employee and pay him $20.19 per hour ($42,000 divided by 2,080 hours per year) for the first 40 hours per week and $30.28 (1.5 x $20.19) per hour for any hour over 40 per week, or

  3. continue to pay Dennis $20.19 per hour and limit his lab time to 40 hours.

Winners or losers?

How does this impact the company and the employee?

It depends. There are a lot of companies with exempt employees earning less than $47,467 per year. These employees, in many cases, work extended hours and carry heavy workloads. As such, for profit-maximizing companies, not having to pay overtime is rewarding.

So, a higher salary hurdle means some of these businesses will have to make a choice based on new marginal costs and benefits. That is, companies will have to identify the marginal benefit of the overtime hours currently being consumed by their employees.

At overtime wages valued at time-and-one-half, Dennis’ 10 hours would cost the company roughly $15,000 (based on his $30.28 overtime wage from the calculation above). That’s well more than double the $5,500 raise necessary to make him exempt from overtime under the new rules. That suggests increasing his salary to $47,476 would be prudent. As a result, Dennis makes more money, but, ceteris paribus (all things equal), the company has higher costs and lower profits.

This sounds awful for companies. Except that the ceteris paribus condition does not hold – not all things are constant.

When companies are forced to reexamine marginal costs and marginal benefits, the people working in these organizations (e.g., any number of my former MBA students) are likely to reexamine the way they are allocating resources and may find that Dennis has a higher return elsewhere in the organization.

Ultimately, this new salary hurdle and rule change might be exactly what the organization needs to change the way it’s thinking, to shuffle around talent or to rethink its business model. There is ample evidence, from Beyonce’s release of “Lemonade” to airlines charging crazy baggage fees, companies and entrepreneurs have shown themselves to be inventive and flexible when the market moves against them.

The big impact

House Speaker Paul Ryan and others have asserted this rule will actually hurt those it’s aimed at helping.

Although Ryan is identified as a big-thinking numbers guy, he’s not thinking big about how companies are likely to work around the final rule issued by the Department of Labor.

Consider the Dennis example above. At $42,000 per year, the company could decide that it wants to make him an hourly employee and keep Dennis working at 50 hours per week. If the company desires to keep its costs for Dennis at $42,000 per year, the company could reduce Dennis’ regular hourly wages so that his annual pay doesn’t exceed that level.

Dennis currently earns $807.69 per week. The company could pay Dennis a base wage of $14.69 (for 40 hours) and an overtime wage of $22.03 (10 hours), and he will continue to earn $807.69 (plus or minus a few cents with rounding). So the end result is pretty much as it was before, except the company will incur the costs of changing the worker’s status and filing regular and overtime wages in payroll and won’t be able to get more hours out of the employee without extra costs. For the most part, this wouldn’t hurt Dennis.

But there are likely a number of workers who are really close to the new salary hurdle (let’s say earning $45,000 per year). In these cases, it is very likely that companies will just bump up their salaries to avoid the headaches and costs of reclassifying the worker and filing straight and overtime wages in payroll.

In these cases the worker is better off, but the company might be a little worse off because of the higher payroll costs.

Then again, the company might not want to engage in the action listed above – dropping Dennis to an hourly position. The efficiency wage theory, championed by economic giants George Akerlof, Joseph Stiglitz, Carl Shapiro and Janet Yellen, suggests that companies are less likely to reduce wages if doing so might increase costs incurred by higher worker turnover, retraining new employees and the like (Alex Tabbarok writes eloquently about this here).

As such, perhaps companies will bump employees like Dennis to the new threshold but limit new hires in the future. In the end, there are few paths that would lead to workers being worse off.

A little push

In any case, companies have a lot of flexibility when dealing with changes like this and can find ways to turn them to their advantage. The impact on the economy depends on how companies and employees perceive this change and the current economic climate when the change goes into effect.

Real wages have been relatively stagnant for the last few year (4-5 percent year-over-year growth), and even in the last few years a majority of people have been convinced the economy was still in a recession. This rule change might be just the right push to start moving wages upward at a faster clip. And that might be enough to convince people that the economy is in an economic recovery.