California state legislators embarked last week on the single most important regulatory misadventure this country has seen in many decades, seeking to redefine the obscure but critical legal distinction between an employee and an independent contractor. The employment relationship today is subject to massive regulation that is inapplicable to the independent contractor, who pretty much works on his or her own.

Like it or not, the employee receives many statutory protections, including the right to receive minimum wages and overtime, to join a union, to receive worker’s compensation benefits and unemployment insurance, and to receive paid family and sick leave. None of that mandated protection comes without significant costs. It has been estimated that reclassification of Uber and Lyft drivers as employees in California alone will cost the two companies an average of $3,625 per driver per year for a combined annual bill of nearly $800 million per year. Nonetheless, in 2018, the California Supreme Court in Dynamex Operations West, Inc. v. Superior Court forged ahead with such a reform by unanimously holding that drivers who worked for a firm that supplied nationwide courier and delivery services should be classified by law as employees and not as independent contractors.

Dynamex teed up a rough-and-tumble debate in the California legislature, which one-upped their state Supreme Court by recently passing Assembly Bill 5 (AB5), a political crusade designed to rescue workers who are “currently exploited by being misclassified as independent contractors instead of employees.” The scope of the legislation goes far beyond drivers, however, raising the pressing question of who counts as an employee and who does not. The bill offers up the general coverage formula articulated in Dynamex requiring that all workers be classified as employees rather than independent contractors unless:

(A) The person is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract for the performance of the work and in fact.

(B) The person performs work that is outside the usual course of the hiring entity’s business.

(C) The person is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.

Next, AB5 exempts a laundry list of occupations from the general rule, including physicians, lawyers, and accountants. But this two-step approach leaves lingering uncertainties. Which other occupations—from tech workers to translators to cleaners—will be caught in AB5’s net?

For many companies, the independent contractor classification is a matter of economic survival. Although AB5’s language of exploitation has a Marxist ring that excites the progressives who dominate the California legislature, these political powerbrokers act as though AB5 targets only well-heeled employers with ample resources to pay whatever freight the legislature charges. But many of these firms operate on shoestring budgets in competitive industries. They, therefore, have neither the extra cash to meet this new burden nor the freedom to raise prices without losing their customers. By imposing its brand of worker protectionism, AB5 ignores the obvious response. Private firms facing economic ruin will take strong countermeasures to blunt the force of this legislation. Yet the only way they can minimize their losses is to either force workers into deals that neither side would prefer to have or to shed these new “employees” in droves.

Think about the predicament of Uber and Lyft, both of which are losing billions of dollars, in part because of the huge regulatory battles sapping their coffers and trashing their business models. What can they do to beat the rap? One move is legal resistance. Right now Uber insists that its “business” is “technology” and that, therefore, all drivers perform work outside its usual course of business. Don’t hold your breath. It is highly unlikely that the California Supreme Court that handed down Dynamex would adopt that sensible line.

Neither is it likely that Uber and Lyft will be able to show that their drivers are “free from the control and direction of the hiring entity.” Some control from the center is an absolute imperative for running these businesses. Both companies must supply their customers with strong brand protection to get potential customers to order a car, sight unseen. These companies must, therefore, set detailed rules about who can become a driver, what kinds of cars they can drive, what rides they can accept or turn down, what kind of insurance they must carry, and what fares they can charge. These rules are as much for the benefit of good and conscientious drivers as they are for Uber and Lyft. Without them, good drivers will suffer as the average quality of performance starts to decline when opportunistic drivers try to free-ride on the brand name.

It should come as no surprise that prior law outside California on this topic was muddled, as courts in individual cases have refused to treat these necessary system controls as dispositive on the question of driver status. Instead, they have concluded that these drivers are independent contractors by looking at the vaunted flexibility of the arrangement, which gives drivers the right to determine when to drive, which rides to take, and when to do outside work. These choices are never given to employees, which is why so many drivers gravitate to these positions for part-time work.

The difficulty with these judicial decisions, however, is that they lack the courage of their convictions. They are only willing to make ad hoc determinations of independent contractor status in individual cases while noting that the balance could be tipped in the other direction in the next case if certain key factors are changed. Here is yet another instance of the need for simple rules in a complex world. At this point, no one has any confidence as to how the next Uber or Lyft case will come out, given that small differences in contract terms or practices could entirely change the analysis.

In light of the high stakes, this ad hoc approach is the road to perdition. No matter how their workers are classified, companies at a minimum must have uniform policies for their workers to manage their businesses and to avoid endless regulatory nightmares. AB5 ends that uncertainty, albeit in the wrong way. At this point, however, the most likely consequence is that Uber and Lyft, if they are able to stay in business at all in California, will have to abandon their current business models. The Fair Labor Standards Act of 1938 supplied minimum wage and overtime guarantees, but only to statutory “employees.” Yet the FLSA leaves that key term “employee” as a largely undefined term that “means any individual employed by an employer.” Not too helpful.

At this point, the writing is on the wall. Lyft has already emailed a message  to its drivers that they “may soon be required to drive specific shifts, stick to specific areas, and drive for only a single platform.”

Why? Because it turns out the FLSA, which was never a good idea to begin with, makes even less sense today. Back in 1938, virtually all workers were paid by the hour, so it was relatively easy for firms to comply with the statutory commands without having to redesign their business models. Today, modern monitoring techniques make it far easier to pay by the ride rather than by the hour. This shift to a more efficient form of compensation benefits both sides. But by the same token, unions, who are fierce backers of AB5, know that they cannot organize a ragtag army of part-time drivers. So they are quite happy to create potential union members out of these newly minted employees. But it is clear that even if Lyft and Uber survive in California, they will employ fewer drivers and offer inferior services to customers at higher rates, all while suffering enormous capital losses from shifting to an inferior business model.

True to form, labor leaders have accused Uber and Lyft of running an “anti-labor misinformation campaign” because “such a change is not written in the law. It would be Lyft’s choice to implement those changes on their own.” Yet that is precisely the point. No company can be in compliance if does not know whether and when given drivers are on the clock or not. No company can comply with AB5 if it is not sure whether it will be charged for driver downtime or charged for some other activity. AB5 may not explicitly order firms to abandon their business models, but it sets up an economic dynamic that forces them to do so.

Ideally, the best way to deal with this unhappy situation is to scrap the FLSA by recognizing that a driver and a technology company are better able to set the terms of their mutual engagement than any government agency. That won’t happen in the short run but, at the very least, a clear FLSA regulation that treats all drivers as independent contractors under the FLSA would go a long way to fix the situation. Californians will come to quickly rue the interventionist court and meddlesome legislature whose misguided mandates will wreck the gig economy.

© 2019 by the Board of Trustees of Leland Stanford Junior University

Published in Economics, Law