The economics of public sector pay

Originally published in Economic Review magazine which provides articles to make recent academic research accessible for A-level students, apply economic theory to real-world situations and sharpen students’ skills.

Nearly 6 million people in the UK work for central or local government, including teachers, nurses, and police officers, to name just a few examples. How much the government pays its workers matters, not only for the living standards of public sector employees themselves, but also for the public finances and the economy more broadly. What has happened to public sector pay in the UK over the past couple of decades? And what should the government be considering when deciding on how much to pay its employees?

What has happened to public sector pay?

Over the past two decades, public sector pay in the UK has been marked by substantial shifts, largely driven by economic crises and government policy responses. Following the 2008 financial crisis, the UK government imposed stringent austerity measures, including for public sector pay. Between 2010 and 2017, most public sector workers saw their pay increases capped at 1% per year, well below the rate of inflation, leading to a significant reduction in real earnings.

As a result, between 2007 and the end of 2023, real average public sector pay actually fell by 1%; in contrast, real average pay in the private sector increased by 4% over this same period. Some high-skill professions, such as doctors and teachers, saw much bigger falls in pay than the average over the same period.

One of the most obvious consequences of this public sector pay restraint was the large amount of strikes in 2023, particularly in the health and education sectors. This caused a great deal of disruption, as operations were postponed and school days were lost. Pay deals reached since then have significantly reduced strike action, but unions have not ruled out further action in the future.

What is the government trying to achieve here?

The obvious question is then: why doesn’t the government just pay its workers more? Ultimately, the government has to make a trade-off between higher public service spending, whether on workers or capital investment, and the taxes, or borrowing, required to pay for it. And this trade-off is harder in a world with total UK public sector debt worth around 100% of GDP, and taxes as a proportion of national income nearing record levels, as we find ourselves in today.

Given the government’s purse strings are rather tight, it faces difficult decisions about what pay increases to offer workers in the NHS, schools and beyond. To help make sense of these decisions, it is useful to consider a rather more fundamental question: what is the government trying to achieve with its public sector pay policy?

It could, for example, use its pay policy to help redistribute income in the economy, by focusing pay increases on lower-paid workers. However, focusing pay increases on lower-paid workers could exacerbate shortages of experienced professionals, whose skills are critical to the effective functioning of public services. More generally, the government has better tools to support lower earners, including the working-age benefit system and the minimum wage, which benefit lower earners in the private sector as well.

Instead, the main objective of public sector pay policy should be to attract, retain, and motivate the right mix of workers needed to deliver the desired range and quality of public services. The government therefore needs to take into account its workers’ ‘outside options’ when setting their pay. If nurses could earn more by stacking shelves in Aldi, for lower hours and less stress, the NHS might start to see staff shortages. Pay dynamics in the private sector are therefore a key input when deciding on public sector pay deals.

Pay and productivity

In the face of budget constraints, both the current and former Chancellor promised to improve productivity in the public sector. In theory, if public sector workers became more productive, then fewer of them would be needed to deliver a given amount and quality of public services. This would allow the government to pay public-sector employees more without increasing overall public spending. Of course, it might want to instead use the savings to reduce taxes – improvements in productivity don’t make the trade-offs disappear, but they do make the options much more palatable.

Productivity in the public sector is, however, notoriously difficult to measure. Normally, we think of productivity as capturing the relationship between the value of outputs produced by a given amount of inputs. But what is the value of a lesson given by a teacher, or of the safety of UK citizens from armed conflict? These services are provided free at the point of use, making it difficult to value them as there is no obvious price.

But difficult does not mean impossible. We can look at, for example, the number of patients treated in the NHS, or the number of teaching hours received by children in state schools and how well they do in their exams to get an idea of the value of some public service outputs. And we can also measure the inputs used to produce the public service, including staffing (e.g. the number of teachers), intermediate goods and services (e.g. the number of textbooks) and the use of capital stock (such as school buildings).

The results of this calculation do not make for good reading for the government. According to the main measure used by the ONS, public service productivity is lower today than it was in 1997, when measurement began. This is partly why public sector productivity has been so prominent on recent chancellors’ agendas. And it’s one of the reasons why it’s been difficult to offer more generous public pay deals.

Conclusion

Around one in 6 workers in the UK works in the public sector, and public sector pay constitutes almost 10% of GDP. Decisions about how much to pay different public sector workers therefore matter, directly for those workers employed by the government, as well as for government finances and the economy more widely.

Public sector pay has stagnated over the past fifteen or so years, with high-skill occupations in particular seeing pay grow more slowly than inflation over this period. Private sector pay has grown more quickly on average, although still sluggishly, raising concerns over the recruitment and retention of public sector employees. Ultimately, boosting public sector productivity would help to ease some of the trade-offs involved, although, if the experience of the past twenty-five years are anything to go by, this is easier said than done.