There is an opportunity to reform how public sector pay is managed

July 13, 2017

It is not surprising that eight years of difficult financial choices that many are questioning whether we might finally be able to loosen up and reach the so-called ‘end to austerity.’ The current debate within the Cabinet about the cap on public sector pay raises important questions, both over long term fiscal sustainability and more micro-economic questions of efficiency. Nobody wants to maintain the current public sector pay cap forever – but equally, simply lifting it will not solve the more fundamental problems with centralised public sector pay bargaining.

Working out the sustainability of present policy is always complex. It requires assumptions about the trend rate of growth, the buoyancy of tax receipts, the frequency of fiscal shocks and the cost of debt interest. Nevertheless, there are good reasons to believe that at 3 per cent of GDP the UK deficit is still too high to reliably see our large stock of debt fall, while significantly higher taxes are likely to be both politically unpopular and harm overall growth. What is more, without significant reforms, increased demand for health services is likely to continue to add further fiscal pressure.

Even if the UK economy was in perfect health, future fiscal demands would be challenging. However, we are currently in a period of significant economic uncertainty, with worries about falling trend growth. Worldwide, advanced economies are seeing sluggish productivity, and we still do not fully understand why. Tax receipts in this economic cycle and in the last cycle that ended in 2008 have been weaker than you would expect for a given rate of GDP expansion. Interest rates remain historically low, but current monetary conditions will not last forever.

In short, any responsible Chancellor is likely only to have limited room for manoeuvre. Realism about fiscal policy will be required for many more years to come. The good news is that there remain substantial opportunities to improve the efficiency of the public services, particularly through the use of digital transformation – but real structural reform is only likely to pay off in the medium term.

According to the IFS, average public sector pay remains around 13 per cent higher than that in the private sector. Much of that is down to the higher skills level of public sector workers, but even adjusting for that still leaves a 3 per cent differential. The gap is still larger if you include other forms of compensation, such as generous public sector pensions.

That does not mean that the pay cap should be simply maintained. Top-down caps are a crude response to a crude form of pay bargaining. We cannot sustainably reduce the deficit by simply cutting wages or benefits, but only by making real structural reforms. In the short term, the pay cap was necessary to maintain a balance with the private sector, who saw sharp real wage cuts in the wake of the financial crisis. Now that the differential is returning to historical norms, the cap is likely to be phased out.

Rather than simply return to the old system, however, we should take this opportunity to reform how public sector pay is managed. In the private sector, pay can adjust to match demand and supply in local markets. In the public sector, pay is centrally determined, taking little account of individual circumstances, skills or local costs. Many people in the public services are arguably paid too little, such as technicians in the NHS, social care workers or skilled software developers.

Uniform national rates of public sector pay distort local labour markets, crowd out private sector economic activity and worsen the quality of public services. Restrictive rules make it hard for public services to compete to recruit the best talent, or provide the flexibility needed for a modern workforce. Recent papers by Propper and Van Reneen (2010) and Britton and Propper (2012) have found that the inability for local public sector wages to keep up with the private sector has led to lower quality hospitals and schools.

A discretionary increase of either public sector pay or more public spending in general is unlikely to resolve the awkward politics of public spending. As important as issues around pay are the unsustainable workloads faced by many teachers or doctors – likely to be solved only by real structural reform, and real productivity improvements. These are not easy problems to solve. In the 2000s, New Labour increased public spending by 50 per cent in real terms. Significant increases in the numbers of NHS staff and teaching assistants failed to significantly lower average workloads.

Reordering priorities within public spending is a sensible political choice for the Government. The public sector pay cap should come to an end soon. However, this should be done in a systematic manner, taking into account the many difficult trade-offs involved, and what is affordable. Ultimately, without significant improvements in productivity, neither public or private sector are going to be able to see sustained improvements in wages.

This article appeared in The Times

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