As the UK Labour Market Becomes Less Flexible and Efficient, is the Minimum Wage Lowering Productivity Growth?
UK labour market is becoming more regulated, minimum wage regulation is compress pay differentials and a Manhattan Skyline of marginal tax rates damages employment and productivity
There are several features of economic policy that are working to make the British economy less flexible and efficient over the medium and longer term.. These include an increased ratio of General Government Expenditure within GDP; a rising tax burden where people are drawn into income tax at lower real levels of earnings given the non-indexation of allowances, an increasing wedge between market incomes and take home pay after tax and payroll social security tax; and a rising regulated minimum wages that have increased as a ratio of median earning and compressed pay differentials. These features of policy were already in play before the July 2024 election and reflected measures taken by ministers in the previous Conservative governments, between 2019 and 2024. The new Labour Government has chosen to aggravate the tax edge on Labour incomes by raising employers national insurance. The proposed Employment Rights Bill to give effect to its Green Paper on Employment will also have a malign effect on employment costs and the flexibility that employers need to take on labour and adjust their force forces as market circumstances change. The UK Government’s Economic Analysis of the bill published in October 2024 suggests that the potential cost effect of the bill’s measures could amount to £5 billion.
Economic history of the British Labour market in the 20th century offers a warning of what can go wrong in employment policy and trade union law.
The UK policy makers should be alive to the need for a flexible labour market and cautious about measures that will impede its economic efficiency. For much of the 20th century the UK labour market among advanced industrial economies, offered a Weberian Ideal Type, of a labour market that did not work . A central feature of the poor performance of the British economy for much of the 20th century was its labour market. It was inflexible and could not adjust to change easily. Adverse economic shocks resulted in quantity adjustments to employment and unemployment rather than changes in prices or adjustments to real wages. The heart of the problem was the passing of the Trade Disputes Act 1906. This exempted people organising strike action from the normal working of the law of tort. This immunity from tort protected trade unions from having to pay damages to employers when their strike action damaged their businesses. The significance of the immunity given by the 1906 Trade Disputes Act was swiftly recognised by people who took an acute interest in industrial law and labour markets.
A Weberian Ideal Type of a labour market that did not clear: Lord Keynes’s ‘institutional’ factors and unemployment in the 1920s Slump years
In the 1920s the consequences of the changed framework of trade union law and the balance of power in industrial relations was revealed. A protracted slump in output generated by monetary conditions that were deflationary as a result of Britain’s commitment to the Gold Standard at the pre 1914 parity, resulted in permanent structural unemployment. Despite the deflationary shock real wages did not adjust which resulted in losses of employment and permanent increases in unemployment. It was an understanding of this that influenced Lord Keynes’s attitude to inflation and the price level. He recognised that wages could not adjust. What he coyly called ‘institutional’ reasons prevented it and advocated fiscal policies to boost demand and raise prices that would bring about a falling real wages and enabling employment to rise and unemployment to fall. The increased price level would enable the labour market to clear, overcoming its own defective pricing mechanism..
Secular rise of unemployment over the economic cycle the 1960s and 1970s
The combination of a tax burden descended down the earnings distribution, the development of social security benefits such as supplementary benefit and earnings related unemployment benefit and employment protection regulation added to the inflexibility of the labour market and institutional power of the trade unions in setting wages. Higher taxes on incomes and more generous benefits that increased the replacement ratio of benefits to wages worked to lower the supply of labour. While higher employer national insurance contributions and employment regulation, such as unfair dismissal procedures and employment tribunals worked to reduce demand for labour . The result was that over several economic cycles when output fell and labour was shaken out, as the economy recovered and output increased, the pick up of employment was weaker and there was increasing evidence of structural unemployment . The result was that each trough and peak in output exhibited a secular rise in unemployment
Employers became more cautious about hiring decisions. Increasingly people with little education, training and labour market experience were at a disadvantage. There was increasing evidence of a segmented labour market where ‘insiders’ were protected with well paid jobs, benefits and occupational pensions and ‘outsiders’ found getting well paid secure work increasingly difficult. When there was an adverse shock to demand employers would be forced to let go of some ‘insiders’ who would then join the ranks of people who found it difficult to obtain work and would experience structural unemployment. In short, higher wages, higher costs from regulation worked to reduce the demand for labour. While higher marginal tax rates applying at lower thresholds of income deterred people from participating in the jobs market.
The full defects of the British Labour market were exposed in the 1980s
When the economy suffered adverse economic shocks employment suffered and unemployment rose. The full defects of the British labour market were exposed in the deflationary shock in the British economy between 1979 and 1981. A severe and unavoidable episode of disinflation that took the RPI down from close to 20 per cent to 4 per cent, resulted in a huge shake out of labour and long delayed structural change in the manufacturing sector. The labour market was very slow to recover. GDP started to recover in the Spring of 1981, but employment did not start recovering until 1983 and unemployment on the claimant count did not start to fall until the summer of 1986.
These structural defects in the British labour market were undone between 1980 and 1990. There was a programme of incremental trade union law reform that narrowed the immunity the trade unions can enjoy when organising strikes. Significant changes were made to unemployment benefits. The link between previous earnings was ended lowering the replacement ratio of benefits to wages. The conditions attached to unemployment benefits were tightened. People had to demonstrate that they were not just available for work but looking for work, the actively seeking work test. The process of testing benefits was transformed by programmes such as Restart and the development of active labour market policies to help people return to work when they lost jobs. Marginal tax rates were lowered and some progress was made in raising the threshold. Trade union law reform changed the balance of industrial relations, and non-accommodating monetary policies directed at low inflation brought about a behavioural change among pay bargainers. In the economic cycles that followed the end of the Lawson boom in 1990, the labour market exhibited much greater capacity to adjust to adverse shocks and to clear at a lower cost in terms of a quantity adjustment in terms of employment and unemployment.
New Labour Government has a policy agenda that will make the labour market less efficient
Sir Keir Starmer’s Labour Government has a series of policies that will work to make the labour market less flexible. The October 2024 Budget announced an increase in minimum wage to two thirds of median earnings. Employer national insurance will increase to 15 per cent and the threshold for paying it will be lowered. There is a consultation on employment protection regulation and trade union law and an Employment Right Bill before Parliament.
These tax and regulation policies work to both lower the supply and the demand for Labour. While generous capital allowances in the corporation tax regime, brought in by Rishi Sunak, give an effective tax subsidy to investment. This results in a tax and regulation framework that exhibits bias against employment that is mirrored in a corporation tax regime that is biassed in favour of capital.
Factors that will mitigate these malign consequences for the Labour market: effective testing of incapacity benefit and active labour market measures
These are balanced by a commitment to active labour market measures to help find people work and appropriate training. As well as ambitious measures to reduce the payment of sickness and disability measures by tightening the testing of incapacity benefit examining the need for the payment of these benefits.Between 2019-20 and 2023-24 claims have grown from 2.3 to 3.1 million an increase in caseloads of 36 per cent.
Lower labour market participation aggravated by Budget’s increase in employers national insurance
The Office of Budget Responsibility OBR is alert to the combined effects of these policies. It projects a fall in the labour participation from 62.7 per cent in 2024 to 62.5 per cent in 2029. This is partly attributable to an ageing population and increases health related inactivity. It identifies the increase in employer NICs as lowering the trend participation rate by 0.1 per cent from 2025-26. The OBR also identifies a fall in the trend in hours worked that are expected to fall between 2024 and 2029.
OBR’s estimate of lower participation rate that falls further as a result of the Budget’s measures
Is UK Minimum Wage Legislation Compressing Pay Differentials?
Nominal earnings in the economy are expected by the OBR to have risen by 4.7 per cent in 2024 and are forecast to rise by 3.6 per cent in 2025. The national living wage will increase by 6.7 per cent to £12.21 for people over 21, for 18 to 20 year olds it will rise by 16.3 per cent to £10 and for 16 to 18 year olds and apprentices, it will rise by 18 per cent to £7.55 .
So far the national living wage has not damaged employment. It was for a long time set realistically at a low rate. The Conservative Government started to raise towards two thirds of median earnings. So far this does not appear to have had an effect on employment. Yet there appears to have been some compression of pay differentials. The minimum wage appears to have become a kind of drag or magnet holding down wages differentials that reflect differences in skill and responsibility . As the minimum wage rose, pay differentials appear to have become compressed. The OBR forecast suggests that this will continue. If the floor to wages rises by 6.7 per cent and overall earnings are expected to rise by 3.6 per cent it would imply a further compression of pay differentials. This compression of pay differentials will be greatest towards the bottom of the earnings distribution.
A labour market needs to function. Wages as a price need to adjust to economic shocks in aggregate terms to prevent economic shocks resulting in structural unemployment. A labour market has to also reward skills and effort that take account of the scarcity of supply in relation to demand. Wages need to reflect the marginal revenue product of workers and that will differ among the workforce. The more accurately pay can be aligned with individual marginal revenue products, the better the labour market will work. A labour market needs to reward differences in marginal revenue product. When pay differentials become compressed, differences in productivity are not reflected in labour market returns. This makes recruitment, retention and motivation of employees more difficult. A labour market that does not take proper account of differences in skill and effort will exhibit disappointing productivity.
The warning from the Low Pay Commission
These concerns about both the affordability of the National Living Wage and its effect on pay differentials have been reflected in the advice of the Low Pay Commission to the Government. The Commission’s Chair Baroness Stroud in a formal letter to ministers National living wage and National Minimum Wage rates for 2025 has explained ‘that employers, especially small businesses, have’ not ‘ found it easy to respond to this large NLW increase. Employers in low-paying sectors are more worried about their cash reserves, debt obligations and risk of insolvency than those in other sectors’.
Baroness Stroud has also told ministers in her letter that ‘employers are also concerned about differentials – the gap in pay between those on the wage floor and those just above them in the pay distribution, including their managers and supervisors. Differentials are more compressed in the low-paying industries and becoming increasingly so. Employers worry it is harming staff retention, recruitment and morale. Some workers have also told us that the reduction in differentials has reduced their incentives to progress’.
A House of Commons research note by Brigid Francis-Devine National Minimum Wage statistics published on 30 October 2024 has explained that ‘since the early 2000s, the adult NMW has been slowly increasing as a proportion of median earnings, as growth in the NMW has exceeded growth in median earnings’. It draws attention to the OBR forecast that the National Living Wage will be 12.46 in 2026, 12.74 in 2027, 13.01 in 2028 and 13.33 in 2029 and 13.33 in 2029.
A Manhattan Skyline of marginal tax rates that has a malign effect on both employment and productivity.
The income tax system developed by the UK since 2010 compounds these factors. Since 2010 the UK income tax regime has started to exhibit a Manhattan Skyline of high marginal tax rates that do not align with top marginal rate of income tax. The Alistair Darling Chancellor in the Labour Government in 2010 introduced the withdrawal of allowances at £100,000, and George Osborne the Conservative Chancellor introduced a taper on Child Benefit at £50,000 into the income tax regime he withdrawal of Child Benefit at £60,000 with a 60 per cent taper and the withdrawal of personal allowances at £100,000 with a 60 per cent taper undermine incentives before individual taxpayer reach the top marginal income tax rate of 45 per cent. These high effective marginal tax rates affect people who are highly productive earning over twice and three times average median earnings.
At the better end of the earning distribution in work means tested targeted benefits are an effective means of relieving household poverty. In the various forms Family Income Supplement, Family Credit, Tax Credits and US Earned Income Credit all involve targeting assistance and removing it as incomes rise. That necessarily involves high tapers or marginal rates of withdrawal, either a small number of households confront very very high tapers or a much larger number of households face a steep but not very very steep taper. These tapers damage work incentives. Yet the key thing is to get assistance to households that need help.The loss of output will not be great given that the marginal revenue product of the people involved is relatively low. In contrast the loss of output from people with a higher level of marginal revenue product earning £60,000 and £100,000 will represent a genuine loss in economic activity and lower productivity.
It is worth noting in this discussion that minimum wages are poorly targeted on poverty, which turns on household circumstance rather than individual circumstances.
Conclusion
The contemporary UK labour market has several factors working to make it less flexible and efficient in the future. They include higher payroll taxes, greater regulation, a tax system that is more onerous and future employment and trade union law will work to increase the costs of employment. There is some scope for tightening the administration of incapacity benefit and other active labour market measures to offset these. As employment costs and risks become greater, the corporation tax system with generous tax expenditures to encourage investment sets up an incentive for employers to substitute labour with greater use of capital.
Functioning prices and incentives are important in shaping employment, effort and productivity.
The compression of pay differentials arising from the working of minimum wage regulation has adverse implications for productivity. The high marginal tax rates of 60 per cent striking highly productive workers earning twice and three times median earnings have negative effects on the incentive to work that also has malign implications for productivity.
Warwick Lightfoot
7 November 2024
Warwick Lightfoot is an economist who was Special Adviser to Chancellor of the Exchequer between 1989 and 1992, before that he was Special Adviser to the Secretary of State for Employment between 1987 and 1989.