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Making pay more responsive to local labour markets makes sense

    As Government Budget leaks intensify, the weekend saw the rebirth of Government’s proposals for public sector pay to be set more in line with local market conditions. The aim is for public sector workers, e.g. the DVLA, Jobcentre staff and civil servants, to have their pay set taking account the conditions of local economies, accounting for differences even within regions. In November's Autumn Statement, the Chancellor had set two calls for research:

    a)      To ask independent Pay Review Bodies to consider how public sector pay can be made more responsive to local conditions (reporting in July 2012)

    b)      To ask the Minister for the Cabinet Office to review how more local, market-facing pay could be introduced in civil service departments

    The rationale behind the move is pretty simple. Private sector pay is subject to an open market, whereas public sector pay is set via national pay bargaining, meaning that in some areas public sector workers are underpaid relative to supply-demand dynamics, and in some areas they are overpaid. This means that pay distorts the local labour supply available to private sector firms.

    Evidence for these distortions is readily available, and can be seen by looking at average hourly wages by region. In Wales, the average hourly wage in the public sector is 30% higher than the private sector, whereas in London average private sector pay is 6% higher than public sector pay:

    Even after controlling for factors like age, education and qualifications obtained, these significant variations still hold. IFS analysis shows, for example, that men working in the south-east have face a negative public sector pay premium, whereas in Wales the premium is +18%. For women, this pay premium is higher still. If public sector pay was more responsive to local demand and supply conditions, there would therefore be huge efficiency gains for the economy.

    The trade unions have understandably reacted badly to the proposals. They claim this is all about making workers in the regions poorer (ignoring differential costs of living). But my understanding of what the Government is proposing is not that pay would be determined by bargaining at a regional level, but that it would be set even more localised within regions, based around the model currently seen for the HM Courts and Tribunals Service.

    Of course, this would still mean a diminished role for national union leaders. But there are reasons why this isn’t the paradigm shift in policy the unions are suggesting:

    1)      The Unions already acknowledge the need for local pay because they endorse the London weighting

    2)      Two of the six Pay Review Bodies (those for doctors/dentists and the armed forces) are exempt from the considerations

    3)      In some social democratic countries like Sweden, pay is determined directly between individuals and the state!

    As an example as to why more responsive pay is a good thing, consider the research undertaken by the Centre for Economic Performance. They find that in areas with strong labour markets and high wages, hospitals find it more difficult to attract staff. This means they tend to have to rely on more agency staff, because they have little scope to offer higher compensation.  Their conclusion is that tightly regulated pay actually leads to more deaths in certain areas. In sectors where pay is unregulated, they find no such effects.

    So what might a Pay Review Body consider? According to the HM Courts and Tribunals Service, the remuneration of senior civil servants considers:

    • the need to recruit, retain and motivate suitably qualified people to exercise their different responsibilities;
    • regional and local variations in labour markets and their effects on the recruitment and retention of staff;
    • government policies for improving public services, including a requirement to meet the output targets for the delivery of service;
    • the funds available to departments and agencies as set out in the Government’s departmental expenditure limits;
    • the Government’s inflation target; and
    • evidence about wider economic considerations and the affordability of its recommendations.

    In other words, what any private sector organisation would do – leading to a better match of workers where needed, and better remuneration for good performance within budget considerations. So long as the costs of administration can be kept low, this looks like an eminently sensible reform which could have profound effects for labour market efficiency.

    Ryan joined the Centre for Policy Studies in January 2011, having previously worked for a year at the economic consultancy firm Frontier Economics.

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