The government should learn from big companies on local pay policy

October 31, 2012

The Heseltine Review, written by former deputy Prime Minister Michael Heseltine is published today. It recommends how growth might be spurred across the country by public sector bodies interacting more effectively with the private sector. One essential part of this plan – although unfortunately not included by Heseltine – is reform of how public sector workers are paid.

Wages for employees across large swathes of the public sector are currently set nationally through collective agreements, meaning they do not vary across the country. The result is that, as a long line of academic studies has shown, large remuneration differentials exist between public and private sector workers. As a rule, compared to their private sector counterparts, public employees with relatively low qualifications, and those in low cost areas of the country, tend to be overpaid. Senior public sector employees, and those in high cost areas, tend to be underpaid.

A recent Policy Exchange report outlined the scale of these differences. In some parts of the country, some public sector workers are paid over 30 per cent more than equivalent employees in the private sector. The gap widens further if more generous pensions, holidays and working hours are taken into account. The report also showed that moving to a localised system of pay setting, allowing public sector pay and pensions to move to match those in the private sector, could save at least £6.3bn a year. A conservative estimate is that this money could create around 288,000 jobs.

With the potential for such large-scale job creation, this is a proposal that everyone should support. Sadly, however, trade unions are united in opposition. One of their main arguments is that many private sector firms also set their compensation packages nationally.

An immediate criticism of this argument is that around half of employees in the UK work in firms with less than 50 employees. For these workers, pay negotiation will be local by default. However, with larger firms, the counter argument is more detailed.

Where the unions are right is that large firms do not tend to have pay rates that vary rigidly across the country. They do not tend to have regional pay. However, this does not mean that reward is managed in the same way as in the public sector. In fact, it is very different. Most firms will have structures of pay setting that deliver both local flexibility and an ability to reward performance. A common approach is for large firms to set guidelines at the national level that dictate the conditions under which pay can vary locally. As one recent academic study reported, these guidelines require “evidence of the rates paid by local competitors, of the local cost of living, and perhaps of local unemployment rates or turnover rates as evidence of market tightness.”

Such guidelines result in a system in which pay awards will both vary individually and be decided locally. They give individual stores or offices the flexibility to vary pay in response to local market conditions. A particular branch of a major firm, struggling to recruit staff, could choose to increase pay to attract employees.

The same is not true in the public sector. Recent academic research has shown that rigid pay structures lead to problems recruiting public sector workers in high-cost areas, as wages cannot rise to meet living costs. These difficulties in recruitment have been linked to increased death rates in hospitals and worse performance of school children in struggling areas.

Looking abroad, we also see that other countries have moved away from crude national pay rates. Sweden is a prime example. Reforms since the 1980s have moved public sector pay negotiation to a system much like large private sector firms. Local negotiations take place within frameworks set regionally or nationally.

The evidence from the UK private sector and from other countries is clear. The UK’s public sector system of national pay negotiation needs reform. Doing so could boost growth and create jobs in some of the areas of the country hardest hit by the recession and could dramatically improve public services. Reform will not be easy nor without controversy. But the need for change could not be clearer.

This article originally appeared on City A.M.’s website

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