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What should public sector pay policy be trying to achieve?

Observation

Whoever is Chancellor of the Exchequer come mid-September will have a bulging in-tray. The current Chancellor, Nadhim Zahawi, is not expected to make any major fiscal decisions before then: these are to be left for the next government. In other words, any policy decisions that can reasonably be delayed, will be.

It is not yet clear whether public sector pay policy falls into this category, but there are signs that decisions could be made before the summer parliamentary recess. These decisions – which will affect the pay and living standards of millions of public sector workers and their families – will inevitably be contentious. Amidst a maelstrom of conflicting arguments and demands, and potentially against a backdrop of large-scale industrial action, the government must make some choices about what pay increases to offer workers in the NHS, schools, police, and beyond. 

To make sense of those choices, it is useful to consider a rather fundamental question: what is the objective of public sector pay policy? What is it, and what should it be, trying to achieve?

Here, I will argue that public sector pay policy should not be set with regard to distributional objectives or used as an inflation- or demand-management tool, as has been implicitly and explicitly suggested. Instead, pay awards should be set so as to ensure that the government can attract, retain and motivate the appropriate number and mix of staff required to deliver the government’s desired range and quality of public services. This, in turn, is inextricably linked to the government’s desired level of overall tax and spending. 

Public sector pay is too blunt a tool to achieve distributional objectives

Public sector pay awards will ultimately have to be met from departmental and local authority budgets. These are underpinned by the government’s spending plans, which were fixed in cash terms last autumn and predicated on pay awards far below the current rate of inflation. On the assumption that those plans are not topped up with additional funding (which seems unlikely, given the focus on tax cuts among the field of would-be prime ministers), pay awards that come even close to matching the current rate of inflation would impose severe budgetary challenges. 

With money tight, the government may be tempted to target the largest pay awards at the lowest earners, who are likely to face a higher rate of inflation than their higher-paid counterparts and are likely to be the ones struggling most with the cost of living. For example, the Scottish Government’s explicit policy is to use public sector pay awards to provide “extra protection to the very lowest paid”. This would follow the policy precedent set since 2010.

But, as we have argued previously (here and here), choosing to once again focus pay awards on lower earners could be risky. More experienced and more senior public sector workers have experienced bigger pay cuts since 2010: the public sector pay distribution has been compressed. A further round of compression could negatively affect the government’s ability to attract and retain the experienced workers – hospital consultants, experienced teachers, senior police officers – critical to service delivery. There may be settings where focusing pay rises on lower-paid groups makes sense, but this should be determined on a case-by-case basis.

More generally, if the government wishes to offer protection to lower earners, it has a myriad of better-targeted policy tools at its disposal – tools which would benefit those in economic hardship in both the public and private sectors. If the government has distributional objectives in mind, things like universal credit, energy bill rebates, and national insurance cuts are far more sensible. Public sector pay policy is too blunt a tool for the problem at hand.  

Pay awards and wage-price spirals

Simon Clarke, the Chief Secretary to the Treasury, has explicitly warned that inflation-matching pay awards risk fuelling an “inflationary spiral”. In its evidence to the Pay Review Bodies, HM Treasury warned of the risks “if public sector pay increases were to exacerbate temporary inflationary pressure". The concern here is that higher public sector pay awards could act to embed higher inflation expectations, triggering a ‘wage-price spiral’ and more persistent domestically generated inflation.

The government is absolutely right to worry about inflation expectations becoming de-anchored from the Bank of England’s 2% target. But it doesn’t necessarily follow that public sector pay awards should be held down as an inflation management tool.

For starters, it is difficult to see how an increase in public sector wages could directly contribute to a wage-price spiral, owing to the lack of prices in the public sector. Higher wages for teachers would not increase the ‘price’ of schooling facing households with children, nor would higher pay for midwives increase the ‘price’ of giving birth in an NHS hospital. One would have to think that higher public sector pay awards would act as some sort of benchmark, pushing up pay settlements in sectors which produce tradeable goods and services. Those sectors may then raise prices, contributing to an increase in economy-wide inflation expectations. This is possible and a justifiable area of concern. However, given that pay in the public sector is currently growing much more slowly than in the private sector (1.8% versus 4.8% in the three months to April 2022, excluding bonuses; 1.5% versus 8.0% if bonuses are included), we might worry less about such spillovers from a policy that sought only to broadly match pay growth in the private sector. Offering 5% pay awards rather than 2% is unlikely to trigger a wage-price spiral in the private sector if pay settlements in the private sector are already running at 5% or higher. Offering 12% pay awards might be more likely to trigger a private sector response.

Of course, an increase in public sector pay would, unless accompanied by offsetting spending cuts or tax rises elsewhere, act to increase aggregate demand. All else being equal, we’d expect that to be inflationary at the margin. But the days of central government aiming to finetune demand in order to manage inflation are long gone. If higher aggregate demand is stoking higher inflation, we have a tool for that: higher interest rates. Looser fiscal policy may well be met with tighter monetary policy from the Bank of England. But that’s not in itself an argument against higher public sector pay awards.

What ought public sector pay policy try to achieve instead?

So, what should public sector pay policy be aiming to achieve?

The government has a quantity and quality of public services that it wishes to deliver. For example, the government’s desire to reduce the NHS elective backlog (in some sense a quality measure) comes with an explicit quantity ambition (30% more elective activity by 2024−25 than before the pandemic). From this flows a staffing need: the government needs to ensure that it has the right number of people, with the right skills, in the right places, to deliver those public services. The government may wish to scale back or abandon some of those objectives, in the face of the UK becoming a poorer nation. That’s a political choice about how the economic pain from a series of adverse economic shocks ought to be distributed – and one that should be made transparently. But it is with these objectives in mind that public sector pay policy should be set, rather than with regard to distributional or macroeconomic objectives.

Pay needs to be (at least) sufficient to attract, retain and motivate the appropriate number and mix of staff required to deliver the government’s desired range and quality of public services. Private sector pay dynamics are likely to be key here, as they will determine the ’outside option’ available for workers who opt to leave the public sector. That might suggest aiming for the same rate of pay growth as in the private sector as a sensible starting point or rule of thumb for policymakers. More generally, pay deals should be set based on an analysis of relevant labour market trends, not driven by headline inflation figures or concerns about inequality.

The desired range and quality of public services is, of course, not determined in a vacuum; it is bound up with the government’s desired level of overall tax and spending. Fiscal constraints are likely to bind. Among Conservative prime ministerial candidates, there is a clear desire for taxes to be lower in the long run (and possibly the short run). Levels of tax and spend cannot diverge indefinitely. Lower taxes must eventually mean lower spending. That is almost certain to mean a reduction in the public services ‘offer’, in terms of quantity and/or quality. That’s especially true in the face of an ageing population, where we will likely need to spend more just for the health and social care system to stand still. Public sector pay awards below the level needed to recruit and retain the required number of staff would be one (relatively opaque) means of reducing the range and quality of services provided, if it led to an exodus of skilled workers or an inability to recruit. Offering higher pay awards without increasing departments’ cash budgets would also mean less service provision, as it would necessitate reductions in headcount or other cutbacks.

It would be preferable for politicians who wish to cut taxes to also transparently indicate which spending and public service areas they would cut back.    

Conclusion

These are trying economic circumstances. An unfortunate series of global economic shocks have made us poorer as a nation. The government is faced with a range of thorny policy problems. It is important that the right policy tool is used for the right policy problem. While the government is right to be concerned about the plight of low-income households struggling to cope with the rising cost of living, and right to be concerned about higher inflation expectations becoming embedded, these are issues best dealt with using tools other than public sector pay policy. Instead, pay decisions should be made with regard to ensuring that the right people with the right skills are in the right places to deliver on public service objectives. If those objectives change – because, for instance, the government wishes to dramatically reduce the size of the state – that should be transparently communicated. A puzzled, opaque policy debate makes these decisions even harder than they need to be.

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