Is the Chancellor right to relax pay regulation in the public sector?

Carol Propper

In a recent surprise announcement to the House of Commons the Chancellor announced that he wants to scrap national pay deals for public sector workers. Labour unions across the land are hitting back, arguing that this will damage public services. In fact, the evidence we have on the effect of national pay regulation suggests exactly the opposite.

National pay awards tend to overpay public sector workers in low cost areas of the country and underpay those in high cost areas. Recent research shows the size of these differentials. For example, the Institute for Fiscal Studies suggests that women working in the public sector in the West Midlands are paid upto 14  percent more than their private sector counterparts. What has received much less attention is that these pay differentials may have an important impact on the quality of public services provided in different parts of the country.

National pay arrangements effective impose a pay ceiling for workers in high cost areas. Simple economics suggests this should impact on the ability of the public sector to deliver services in these areas. The lower wages offered to public sector workers relative to their private sector counterparts in high cost areas will mean, all other things equal, that the public sector will struggle to recruit and retain the best quality workers. This in turn will mean problems in producing services.

Recent work undertaken at the CMPO and the London School of Economics confirms this intuition in a very stark setting. Analysis of the impact of national pay regulation of the wages of over half a million nurses in the NHS showed that hospitals in high wage areas had higher death rates for patients who were admitted following a heart attack.  Furthermore, the output of hospitals in low cost areas such as the North East did not appear to compensate for the lower quality output of their counterparts in the high cost South East. Our research suggested that deregulating pay to reduce the gap between nurses pay and that of their counterparts in the private sector would both save lives and cut costs. So in this case both economic intuition and the Chancellor’s instincts are right: deregulating public sector wages will improve the quality of public services.

Further details of the research can be found at: Propper, C and Van Reenen J (2010). Can Pay Regulation Kill? Panel Data Evidence on the Effects of Labour Markets on Hospital Performance. Journal of Political Economy 118 (2): 222-273.

Deregulating public sector pay

Carol Propper

 

The Coalition government is concerned about public sector pay and has instigated a review chaired  by Will Hutton. Hutton has signalled that he will be looking at it the level of pay, both across sectors and within the public sector. However, one issue on which there have been fewer pronouncements to date is the regional variation in pay within the public sector.

Pay in the public sector for doctors, teachers, nurses, armed forces and other public sector workers is set by the Pay Review Bodies. These bodies review the state of the labour market and recommend a level of pay for to the government and the unions each year.  Public sector unions often stress fairness in their wage negotiations: the commonly articulated view is that a teacher in an inner city should in Newcastle does the same job as one in inner London and should therefore be paid the same wage.  Perhaps as a result of this argument the review bodies basically set one wage for all the workers they cover, regardless of where they are located in the country. There are extra increments for those located in the South East and London, but these tend to be small. The result is that wages in the public sector tend to be much ‘flatter’ across geographical space than private sector wages. As an example, the difference in the pay of a nurse located in the North East and London is around 15%. However, the difference for a private sector employee with similar skills to a nurse is in the order of 40%.

Such large gaps are likely to cause recruitment and retention problems for public sector employers in the South East as their workers live in a high cost area and as a result will be offered higher wages  in the private sector. Shortages of nurses and teachers in the South East have been an ongoing and well documented problem. But is is likely that these recruitment and retention problems also have a knock on effect into the productivity of public sector services in high cost areas. Shortages of workers, high turnover rates and perhaps low levels of morale as a consequence, are likely to cause production problems. CMPO research on nurses’ pay has confirmed this intuition: centralised regulation of nurse pay caused extra deaths per year amongst patients admitted to hospital following a heart attack. They also calculated that wage regulation didn’t even save the government much in direct wage costs as the benefit of lower wages bills in the South East was offset by higher pay in the North of the country so the wage savings were small. The reason for the small wage savings were that the pay review body gets the level of wages ‘right’ on average – what they get wrong is the extent of variation across different parts of the country.   These seems very plausible: the review body takes evidence from a wide variety of sources and probably therefore sets the average level correctly, but in responding to union (and perhaps also public) pressure for equality in the public sector, gives insufficient weight to regional variation.

It is likely that public sector pay regulation affects the ouput of teachers, policeman and other public sector workers in a similar way, though this is still to be confirmed.

This all suggests that in addition to examining the level of public sector pay, Hutton should be equally concerned with the variation in pay across regions.  One solution might be to deregulate pay altogether and let each employer negotiate with their local workers. However, this also has costs. First, and most obviously, such wage negotiations are costly for both employers and workers in terms of time and the need for each employer to employ HR personnel skilled in wage negotiation. But second, in labour markets in which there is a shortage of workers, negotiations between single employers and their workers may simply drive up the price of labour for all local employers as employers seek to outbid each other to attract staff. This means that no single school or hospital will wish to engage in such negotiation, because any advantage they initially get from offering a higher wage, will be quickly eroded as other local employers follow suit. Whether for the first and/or the second reason, it is the case that hospitals in England, when given the freedom to negotiate local wages in various NHS reforms have generally not done so.

The solution might be therefore to retain the pay review bodies but to ensure that they allow for much large wage differentials across the country. In so doing, they will have to resist calls from the unions – and possibly the public – for equity in pay setting. But far from being fair, such equity penalises public sector workers in high cost areas, over-reward those in low cost areas and probably harm the users of the services these workers provide.

Spending cuts and public sector productivity

Helen Simpson

 

The coalition government plan to implement substantial cuts in spending on public services, with most departments having been asked to find budget cuts of 25%. The government hopes to achieve these cuts without such radical effects on what it delivers. The up-coming Spending Review aims to make efficiency savings and “to consider how to deliver a step change in public sector productivity”(i.e. the ratio of public sector outputs to inputs).

Public service reforms may deliver genuine efficiency improvements, but even in their absence the spending cuts are is likely to be successful in increasing measured productivity in the public sector. The graph shows the National Statistics measure of public sector productivity from 1997 to 2008. Productivity falls as the increase in inputs outstrips the growth in measured output. As inputs decrease this is likely to be reversed. Measuring the quality of public sector outputs is extremely difficult[1] – just as the numbers may not include all quality improvements as inputs rose, the output measure may miss any deterioration in service quality as inputs fall, leading to an increase in measured productivity.

Source: UKCeMGA: Total Public Service Output, Inputs and Productivity (2010)

With the prospect of public sector pay freezes, quality decreases may arise through talented staff leaving for the private sector. Research suggests that remuneration over the lifetime is roughly similar in the public and private sector with a small public sector premium.[2] Hence there is a risk, with public sector pay frozen, and if jobs become available, that quality will decrease if some of the most able employees go private.

Shifting a substantial fraction of activities out of the public sector, for example to be delivered by charitable organisations, could also increase public sector productivity if those services were relatively resource intensive and low productivity. But then comparing the performance of total publicly-provided services over time, and inherently the performance of successive governments, would not be meaningful as the measure would not be comparing like with like.

 

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[1] H. Simpson, (2009) “Productivity in public services”, Journal of Economic Surveys, 23(2), 250-276

[2]Postel-Vinay, F. and H. Turon, 2007, “The Public Pay Gap in Britain: Small Differences That (Don’t?) Matter”, Economic Journal, 117, 1460-503.

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