Osborne’s National Living Wage: Why it won’t work and why it just might

Despite all the rhetoric about the Conservatives becoming the workers’ party, George Osborne’s masterstroke National Living Wage (NLW) is really just another deficit reduction policy. The government has realised that the deficit is a labour market thing and that the only way to take big lumps off social security costs is for a lot of people to earn a lot more than they do now. Solution? Get employers to pay more, so fewer people will need in-work benefits and the welfare bill will go down. Or, to put it another way, get employers to cover some of the cost of deficit reduction. That way, you can cut welfare costs without causing social unrest and, with a falling benefits bill, you don’t have to cut as much off public services. Simple eh?

Why it won’t work

This won’t work, says just about everybody. Among others, the Institute for Fiscal Studies, the Resolution Foundation and the Joseph Rowntree Foundation have published reports with charts of doom explaining why most of those currently on in-work benefits will be worse off.

These IFS charts show the changes in income resulting from the tax and benefit changes announced in the budget and from the NLW, spread across the income distribution.

Screen Shot 2015-10-29 at 17.15.03

The problem here is not just the amounts, it’s also the distribution. The NLW won’t increase earnings by anywhere near the amount that benefits are being cut but it will also favour those whose benefits are being cut least. As the OBR explained straight after the budget in July:

Although the NLW boosts individuals’ earnings towards the lower end of the individual income distribution, it is expected to have a more even effect on the distribution of household incomes, since many workers on the NLW will be households’ second earners. Indeed, around half the cash gains in household income may accrue to the top half of the household income distribution.

The Resolution Foundation’s analysis drew similar conclusions. The NLW will mitigate the benefit cuts slightly but those at the lower and of the income distribution will still take a big hit.

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The NLW might also lead to some job losses or reduce the rate of job creation. The OBR puts the figure at 60,000 fewer jobs but others believe it will be much higher. Recruitment agency Manpower says that companies are already scaling back recruitment. If employers know they will have to pay higher wages but can’t be sure they will generate the revenue to pay for it, they might be tempted to increase the use of zero hours contracts or outsource more work to the self-employed.

Worse still, as Michael has shown, the cuts to tax credits fall disproportionately on those in-work. It might be that the work incentive, brought about by in-work benefits over the past two decades, goes into reverse. For the government, there is no point in reducing the in-work benefit bill only for the cost of unemployment benefits to rise.

If the government succeeds in taking £12 billion out of the welfare budget it is likely to lead to serious distress for many people and possibly social unrest, even with the rise in the minimum wage. If it fails to do so, it must either take more cost out of public services, increase taxes or abandon it’s deficit target. All these options will be politically damaging.

Why it might

Having said all that, no-one can be sure about the impact of the NLW because the government has never pushed up the minimum wage by so much over such a short-time. Neither, for that matter, has any other country, although a few are now trying something similar. As the Economist says, what might happen when the UK, France, Germany and the US push up their minimum wage is anybody’s guess:

By moving towards sharply higher minimum wages, policymakers are accelerating into a fog. Little is known about the long-run effects of modest minimum wages. And nobody knows what big rises will do, at any time horizon. It is reckless to assume that because low minimum wages have seemed harmless, much larger ones must be, too.

If nothing else, the government is in tune with the zeitgeist and if the NLW fails, Britain will be in good company.

But there were blood-curdling warnings about job losses in many countries when minimum wages were introduced. Most of them came to nought. Economic theory might say that such a wage hike will lead to job losses but we can’t be sure.

There’s also the question of the impact of higher wages on productivity. Do wages rise when productivity rises or do higher wages lead to higher productivity? The efficiency wage hypothesis argues just that, as Ben Chu explains:

First, paying workers more than the bare minimum discourages them from shirking. They give more effort during their working day. And firms don’t need to employ so many managers to supervise their shirking workers, thus saving money.

Second, higher wages mean workers are keener to hold on to the job in question. They don’t hand in their notice so often and that reduces the firms’ turnover costs. It’s expensive and time-consuming to advertise for new employees, to interview them, to process their paperwork and to train them up.

Finally, decent wages relative to the rest of the market can mean workers are more loyal. They feel more valued and are prepared to work harder as a result. Most of us can probably relate to those explanations.

There is evidence from low-paying sectors to back this up. An LSE study in the care home sector found that higher wages reduced the level of shirking and the amount of supervision needed for care assistants. This, concluded the authors, is “indirect evidence of productivity enhancing effects of higher wages”. A NIESR paper earlier this year found:

[T]he increases in labour costs associated with the NMW were associated with increases in labour productivity in all three periods considered and that these arose due to increases in efficiency (TFP) rather than capital labour substitution (capital labour ratio).

But, as with the labour cost increases, there is a concern that these effects capture an element of mean reversion (the tendency for low-productivity firms to catch up to the industry average).

In other words, it could be that a hike in the minimum wage might increase efficiency in that long-tail of poorly managed low productivity firms.

If people cost more, it might also encourage firms to invest more. At an ACAS discussion I went to earlier this week, John Lewis chairman Charlie Mayfield gave an example of this from his sector. In many French supermarkets, the prices are updated with digital displays on the shelves. There is no point, he said, in doing this in the UK as it is cheaper to pay people to go round and update the prices. In France, however, with labour costs being much higher, the investment in the computerised system pays for itself. There is some evidence that the UK’s low wage economy is encouraging low-tech low productivity businesses. Increased labour costs might help to reverse that trend.

More expensive workers might also be an incentive for employers to invest more in them. If you have to pay more for your people, it makes sense to get the most you can out of them. Training them and training people to manage them more effectively becomes more cost-effective if labour costs are higher. Increasing the minimum wage might stop the decline in training which has pretty much tracked the fall in wages since the mid-2000s.

If the NLW were to kick-start a productivity boost it would be good news for George Osborne. As Adam Corlett said, if productivity were to grow at the rate it did in the 1970s and 80s for the next five years, we wouldn’t need any spending cuts at all. That’s unlikely to happen but any productivity growth above the forecast would be a welcome bonus for the chancellor.

Even so, an unexpected productivity boost and higher pay rises probably wouldn’t be enough to offset the benefit cuts. As Paul Johnson said:

[T]he increase in the minimum wage simply cannot provide full compensation for the majority of losses that will be experienced by tax credit recipients. That is just arithmetically impossible. The gross increase in employment income from the higher minimum wage is about £4 billion. Welfare spending as a whole is due to fall by £12 billion and, even excluding the effects of the four year freeze tax credit spending is due to be cut by getting on for £6 billion.

But then again, it doesn’t need to. At least, not completely.

For the National Living Wage to work for the chancellor, all it needs to do is boost incomes and productivity by just enough. Just enough to raise the tax take. Just enough to mean that the hardship isn’t quite bad enough to cause social breakdown. Just enough to lower the benefits bill by just enough to soften the cuts to public services, so that, while they lurch from crisis to crisis, they somehow carry on. In short, just enough to squeak past the deficit target without major civil disorder or service collapse. Just enough for the chancellor to emerge triumphant at the end of the decade. St George of Osborne, champion of the poor and slayer of the deficit dragon.

Now, before you tell me I have taken leave of my senses, I think that even this is unlikely. The numbers the chancellor needs to make up are so big I still reckon he will end up shifting his deficit target or quietly raising taxes.

And yet, I still can’t help thinking what if, what if….?

I can’t quite banish from my mind the possibility that George might pull this one off, that he might just stagger across the deficit finishing line, battered and bruised but having avoided a major political catastrophe. If he does, surely the Tory leadership and the 202o election will be in the bag.

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12 Responses to Osborne’s National Living Wage: Why it won’t work and why it just might

  1. Pingback: Osborne’s National Living Wage: Why it won’t work and why it just might | Flip Chart Fairy Tales | sdbast

  2. Jim says:

    “paying workers more than the bare minimum discourages them from shirking. They give more effort during their working day. And firms don’t need to employ so many managers to supervise their shirking workers, thus saving money.

    Second, higher wages mean workers are keener to hold on to the job in question. They don’t hand in their notice so often and that reduces the firms’ turnover costs. It’s expensive and time-consuming to advertise for new employees, to interview them, to process their paperwork and to train them up.

    Finally, decent wages relative to the rest of the market can mean workers are more loyal. They feel more valued and are prepared to work harder as a result. Most of us can probably relate to those explanations.”

    How can these factors apply when everyone gets a pay rise? When whatever job you go to, the pay will still be at the higher level? A care home worker gets the new NLW, how does that make him or her likely to work harder in order to keep it, when they know every other care home worker earns the same?

    The only way the above factors work is when the employer paying extra is the exception, not the rule.

    And the NLW will raise productivity, just at the expense of employment. All the jobs that are currently marginal vs automation will suddenly have been priced out of the market.

  3. thenextwavefutures says:

    The research done into Costco at Harvard suggests there’s a second order effect of higher wages and staff retention: knowledge remains in the business, and that even in a low wage lower-skill sector such as food retailing that knowledge makes a difference to performance, both individually and at a business level.

  4. thenextwavefutures says:

    @Jim Still on retail: the most successful retailers at the moment – such as Costco and Mercadona – pay higher wages, invest in training AND technology, and direct their staff (whom they still employ in significant numbers) to useful revenue-generating tasks such as inter-acting with customers.

  5. Truth to Power says:

    In essence ‘tax credits’ are a subsidy that allows employers to keep their pay bills low. It might be argued that this is good for all companies who have low paid employee’s to survive. The problem is that it allows what would be unviable companies to survive. By reducing that subsidy would cause companies to fail and increase unemployment … however they should have failed anyway. Removing such companies creates space to allow viable companies to be born “Creative Destruction’.

    Though harsh this would ultimately be a good thing. ‘Minimum Wage’ and ‘Living Wage’ are bad ideas as it encourages wealthy companies to pay employees as little as possible … retail seems to be a good example of this.

    Creating a ratio between the highest and lowest paid (including bonuses, etc.,) within a company would seem much more sensible

  6. ballantine70 says:

    Have you seen anything indicating what proportion of those currently receiving in-work benefits work in the public sector? Whilst the NLW might reduce the DWP’s budget, public sector workers wage increases would have to be funded from somewhere…

  7. duncan brown says:

    Rick, as well as encouraging firms to increase their training investment, there is quite a lot of evidence particularly from the US that skilling up employees and paying for skills pays off for the employee, with higher added value work adding proportionately more to employer profits, and higher performers also adding more value than average performers in high skilled jobs. OK, so i know this was Gordon Brown’s old argument for avoiding price competition with the Far East, but there is good research support. eg file:///C:/Users/duncanibrown/Downloads/WoodMenezes1998.PDF in UK, http://www.siop.org/userfiles/image/SIOP_SHRM_Skill_Based_Pay.pdf in US and in Poland http://onlinelibrary.wiley.com/doi/10.1111/j.1468-0351.1996.tb00163.x/abstract;jsessionid=AFF62AFB60847152D7864AD9027E2A51.f03t04

  8. ChrisA says:

    Of course the standard answer as to these claims that higher minimum wages increase firms efficiency, is if that is so, then why are these firms not already paying more than the minimum wage? If it were really true that paying higher wages pays off, then firms that pay higher wages should out-compete with those that don’t.

    But this is pretty irrelevant for this discussion as Osbourne is a politician first of all, not an economist and I think he is thinking mostly about short term effects (2 to 5 years) on his agenda. Longer terms policies for policiticans are not worth thinking about – too much can happen in the long term to make any kind of long term policy thinking worthwhile. This is why Rick can say that the empirical evidence on minimum wages is ambiguous, sure ceteris paribus higher minimum wages are bad for employment, but when has any economy ever been ceteris paribus? So for Osbourne he knows that if all companies are forced to raise the minimum wage at the same time then they can’t undercut each other (unlike the case where one company decides on their own to increase wages). So the short term impact is on profits not employment. No company would let their capital assets sit idle if the cash costs of operating them are cash flow positive, even if they are not returning an adequate return on the sunk capital. The impact of a MW wage increase is all on the future, either by offshoring jobs or by investing in productivity enhancing technologies. But the effect of this won’t been seen for many years. And in any even these low wages jobs would probably have been the jobs that would have been automated out or offshore anyway, since they are the easy ones to do so (by definition otherwise they would be highly skilled high pay jobs).

    Osbourne has even increased this effect by delaying the increase by a number of years. I can only hope that he is a clever in running the country as he is in playing politics.

  9. duncan brown says:

    As well as encouraging employers to invest in staff training, if employers use skills related pay as the basis for the increase required and beyond, there is quite a lot of evidence that this gives a greater return than the cost of the increase. OK so i know this was Gordon Brown’s old argument for UK industry moving up the value chain so as not to compete with Far East employers on price. But there is actually quite a lot of evidence that higher skilled workers do add more value to their employer, and that high performers add proportionately more value than average performers in higher skilled jobs – in the UK, file:///C:/Users/duncanibrown/Downloads/WoodMenezes1998%20(2).PDF
    in the US http://www.siop.org/userfiles/image/SIOP_SHRM_Skill_Based_Pay.pdf
    and in Poland http://onlinelibrary.wiley.com/doi/10.1111/j.1468-0351.1996.tb00163.x/abstract;jsessionid=4118F93537A989ADC7508D50C399CBEF.f02t04

  10. Pingback: Osborne’s National Living Wage: Why it won’t work and why it just might | Flip Chart Fairy Tales | Vox Political

  11. P Hearn says:

    This is going to be an interesting experiment. Some states in the US are implementing a relatively high minimum wage, and that too will be interesting to observe in terms of the effects on employment, economic activity and public sector borrowing.

    There’s no doubt that the tax credits budget has expanded way beyond what was ever envisaged or intended, but any benefit, once given, is very hard to take away.

    Those in low skill jobs will now face the risk of their job being automated or sent offshore, but let’s see what happens. Perhaps the Left has been correct about this all along, and high wages will simply make us richer as those people spend the money and velocity of circulation of money increases. In which case, let’s all look forward to the £100k cleaner, and just hope that inflation remains benign.

  12. Simon Jones says:

    I think there is an interesting crossover of HR and economics here. I work with a childcare nursery that pays NMW to its basic grade staff and 50p an hour more to those with a slightly higher qualification. They have very low staff turnover because they invest in training and also take steps to ensure that the nursery is a “nice place to work” – and even when historically some competitors paid more their turnover did not change dramatically . The change to NLW will have an effect on them but also on their competitors who pay at similar levels. So they will be in no worse competitive position than previously (with the caveat that some staff may want to withdraw from the labour market because they are worse off after the tax credit changes) and are able to maintain a competitive advantage for labour for non-financial reasons. While some jobs may be automated or sent offshore, there are an awful lot of low pay sectors where labour cannot easily be substituted – I can see that both options presented could be right

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