21 May 2015

The case for a living wage


When Winston Churchill declared in 1909 that it was “a serious national evil that any class of His Majesty’s subjects should receive less than a living wage in return for their utmost exertions”, he was speaking to a Britain which was poorer and sicker than anything we might imagine now. People could expect to live for 30 years less than they do now and real annual earnings were a quarter of what they are now but they worked on average for 20 hours longer a week. Britain today has one of the fastest growing economies in the developed World with a record high employment rate and a falling budget deficit. Politicians in other countries mired in economic stagnation are clamouring to find out what it is that we have done so well over the last few years. Yet the one key area which has disappointed is the weak growth of real earnings.

Wages have finally begun to grow in real terms but until recently, this has been in large part because of subdued inflation rather than stronger nominal wages. As unemployment continues to fall and part-time workers move into full time work, the labour market will tighten and nominal wages will rise to reflect the need to fill vacancies and the improved bargaining power of workers. With regular pay in the private sector drifting up by 2.7% over the last year, there is certainly evidence that this is beginning to happen. In the long term, productivity must rise to support sustained growth in real earnings so it is critical that the Government introduces policies which improve Britain’s weak performance in this area. Planning reform, skills development and improving infrastructure amongst other measures will be necessary.

There are of course other proposals which the Government might consider to help raise living standards, especially for lower earners. One of these is implementing the Living Wage which is currently £7.85 per hour and £9.15 in London compared to the National Minimum Wage of £6.50. The Government is committed to raising the Personal Allowance to a level such that nobody working 30 hours a week on the minimum wage will pay income tax. Significantly increasing the employee national insurance threshold too would create a de facto living wage as workers can keep more of what they earn in the first place.

The moral case for cutting the taxes of the lowest paid workers is incontestable. Britain should be a country in which if people go to work, they know that they will earn enough to eat and stay warm at night. People should always be better off in work than staying jobless but too often low pay, a disastrously unreformed welfare system and the extra costs of work such as travel and childcare have meant that has not been the case for an unjustifiably high number. Many more have become reliant on in work benefits to supplement their incomes and this year we will spend £29.5 billion on personal tax credits, the bulk of which is topping up low wages. Even excluding those on Job Seekers’ Allowance, we will spend £22.2 billion on housing benefit and the proportion of people in work who are receiving housing benefit has more than doubled over the last six years: a reflection both of rising house prices and weak real wage growth. If low earners are taxed less, there will be less of a need to supplement post-tax incomes with in-work benefits and people who are out of work will have a stronger incentive to move into a job.

However, simply raising the national insurance threshold does raise some issues and perhaps the most difficult is the fiscal constraint. Raising the national insurance threshold for employees implies at least several billion pounds of spending cuts elsewhere in addition to those already planned. Finding further such spending cuts will be difficult but if it can be done, it should be done. However, if the fiscal challenge of raising the national insurance threshold is too great, should the Government embrace the Living Wage? I believe that if accompanied with business tax cuts, appropriate age banding and a long enough entry period, then implementing a national Living Wage through gradual increases in the minimum wage could be quite an effective tool without too many adverse consequences.

Improving productivity and cutting the tax burden should of course come first but a higher legal minimum wage would certainly provide an income boost to the roughly five million people who earn less than the Living Wage. There are 2.5 million people on and up to 50 pence above the minimum wage and an increasing proportion of these people have become stuck there. Raising the minimum wage to a living wage would give many the dignity of being able to provide for their families whilst simultaneously sharpening the incentive for people out of a job to get back into the labour market. In doing so, dependency on a cumbersome welfare state would fall as the need to claim tax credits and other benefits diminishes. It would also reach people, especially many of the 6.9 million part-time employees with median hourly earnings of £7.80, who pay little or no income tax or national insurance anyway.

There is also a lot of evidence showing that raising wages on the lower end of the labour market tends to boost productivity and these gains are sometimes unanticipated by firms. Higher wages motivate staff to work harder as well as leading to less staff turnover, increasing quality, better customer service, fewer disciplinary problems, less absenteeism as well as less having to be spent on supervision amongst other things. In addition to workers, businesses also react to minimum wages by raising productivity; not necessarily by reducing workforces but by, for example, improving training. These gains do not seem to be acquired solely by first-movers either.

For every £1 increase in low wages the Government would receive about a 50 pence fiscal boost due to lower welfare payments and higher tax revenue from higher incomes. If the Government decided to implement a Living Wage, it could use this fiscal boost to cut business rates or employers’ national insurance contributions to cut the cost of hiring workers. The Government could announce its intention to reach the Living Wage through gradual increases in the minimum over perhaps five years to give firms plenty of time to plan and prepare. It could also add to the existing minimum wage age bands a new band for workers perhaps between 21 and 23 to make it less likely that younger workers are priced out of the labour market.

There are of course arguments against implementing a Living Wage. It is not a good measure of poverty because individual circumstances are different, it does not reflect regional price differences and it cedes too much intellectual ground to people who have just lost the election. It is worth going through these arguments in turn.

Individuals of course face different costs and a living wage rate is by no means perfect. It won’t be sufficient for some and for others who are secondary earners it might be unnecessary. However, whilst we should seek to make improvements to the measure, it does seem to be a reasonable approximation of a basic standard of living which is worth having as a benchmark. Prices vary quite significantly across the country but the separate London rate does reflect the normal corporate practice of having a weighting for London. There may be a case for regionalisation in the Living Wage in the same way that there is also a case for it with public sector pay and benefits more broadly.

It would also be misguided to view this as ceding too much intellectual ground. The minimum wage has already established the principle of a wage floor as a form of protection from exploitation. The Government should keep out of price-setting where possible but even if abolishing the minimum wage was desirable, it would be politically impossible. If the Right has accepted the principle of the minimum wage, why not claim it for its own and use it in a way which will raise living standards and not damage employment whilst tying it with tax cuts, deregulation and other supply-side measures?

This brings me to what is by far the most important argument against a Living Wage which is that it could damage employment. Internationally, there is little evidence that minimum wages cause firms to fire workers but there is evidence that it might lead them to hire fewer new people; there may also be more subtle changes such as a reduction in the number of hours and perks. This seems to affect younger workers and low paying sectors the most. In the UK, whilst some minimum wage dominated sectors have seen prices rise faster than non-minimum wage sectors, the broader effects appear to have been very small – including for younger people. The evidence suggests that the increases in labour costs in low-paying firms have been met by increases in labour productivity, not from reductions in employment but from increases in Total Factor Productivity. Nor does there seem to be robust evidence that the minimum wage has changed average employment or investment rates in low-paying firms. Around 140 research projects conducted for the Low Pay Commission have shown that the minimum wage has had little negative effect on employment and the low paid have received higher than average wage increases.

Although, just because the minimum wage hasn’t had a particularly damaging effect so far, there is no guarantee it would be the same if it was increased more significantly in the coming years to reach the living wage rate. Indeed, a high wage floor must at some point create unemployment. Modelling carried out in 2013 estimated that an immediate increase in the minimum wage to the living wage for all employees could reduce total employment demand by 160,000. There would be significant switching from younger, unskilled workers to older and more experienced workers. The retail, hotel and catering sectors are likely to be most affected and for bars and restaurants, the average firm level wage bill would see an estimated increase of 6.2% which might be 2-3% of overall costs. Elsewhere the increase in costs would be lower.

However, this seems to be a ceiling and is not a prediction of what might actually happen to employment because it does not consider a number of other factors such as increases in efficiency and scales of production. Also, the same model would have forecast a substantial reduction in labour demand following the introduction of the minimum wage, something which appears not to have happened. The model estimates an increase in gross earnings of £6.5 billion and a £3.6 billion boost to the Treasury so it is reasonable to expect a subsequent rise in consumption increasing demand for labour elsewhere. Earlier forecasts from the IFS suggest a similar ratio between the increase in gross earnings and the Treasury gain.

Furthermore, if the rate is set lower for younger workers by adding another age band and some specific exemptions are included, the most distortionary elements of the higher minimum wage can probably be mitigated, although of course the increase in earnings and the boost to the Treasury would be less too. If alongside this, the Government cuts business taxes by the amount that it gains from higher revenues and lower welfare spending, then it seems likely that the negative employment effects can be heavily reduced. With such a buoyant labour market, now seems a good time to start the process and if the employment effects do appear significant, the minimum wage rise can simply be frozen.

With some justification, we worry about the effects of higher minimum wages on youth employment. Yet, the longer term problem is that we still have young people leaving formal education without the skills or capabilities to be able to earn a decent wage. Equally, some sectors which have yet to experience a burst of productivity growth or even much take-up of technology remain stuck in a low-paying, low productivity cycle. This does seem to have become self-perpetuating. The growth in the tax credit bill in recent years has been driven by people in work and at least to some extent this means taxpayers are subsidising businesses to pay low wages. 70% of tax credits are paid to in-work families and £8.6 billion of the increase in the tax credit bill between 2003/4 and 2012/13 came from those families compared to a £3.8 billion increase from out-of-work families.

Dramatically improving education, training and skills development are thus critical in raising productivity and pay. Moreover, it might actually be the case that knowing the minimum wage will rise over several years will push firms to become more innovative and raise productivity. If the employment effects can be kept minimal or even eliminated, especially in combination with tax cuts, then raising the minimum wage to reach a living wage can be part of a powerful programme to raise living standards.

 Adam Memon is Head of Economic Research at the Centre for Policy Studies