Impact on Firms

2.91 When recommending an appropriate rate for the National Minimum Wage, the Commission aims to benefit those on low pay, but also to ensure that businesses will be able to accommodate the recommended increases. This section examines the impact of the minimum wage on some key indicators of company performance: the wage bill, profits, productivity and prices, and business start-ups and failures.

The Wage Bill

2.92 In the 2004 report the Commission committed itself to a review of the methodologies used to estimate both the number of minimum wage beneficiaries and the impact of the minimum wage on the total wage bill. The methodological issues involved in estimating beneficiaries have been discussed earlier in this Chapter. Our review of the methodology for estimating wage bills suggests that the technique used in past reports is reasonably robust.

'The overall UK economy performed very creditably during the second half of 2003 and the first half of 2004. However, the profits-to-GDP ratio remains well below the peak seen in the late 1990s cycle and the CBI is sceptical about the ability of this ratio to recover much in the short term. This relative squeeze on profits means that any increase in the NMW will be much less affordable than might be implied by simply looking at the state of the macro-economy.'

CBI evidence

2.93 The direct effect of the minimum wage on firms is through higher labour costs which increase the wage bill. In order to estimate the effect of the October 2004 upratings, we need to establish a counterfactual and ask what would have happened to wages in the absence of the increase. To do this, we need to make two assumptions: what would have happened to the earnings of those paid below the new rate had there been no minimum wage increase; and would the shape of the earnings distribution above the minimum have been any different - that is, has the uprating affected differentials in a way which changes the distribution?

2.94 In our fourth report (2003), we adopted two alternative assumptions about the growth in earnings of the low paid in the absence of a new rate. The assumptions were first, either that earnings would grow at roughly the same rate as the growth in average earnings or that these earnings would grow at roughly the same rate as the growth in prices.

2.95 The second assumption we need to make is about the effect of differentials on the earnings distribution. In our fourth report we assumed that the impact on differentials would be limited to around the sixteenth percentile. These assumptions were based on data for 2000-2002. As can be seen in Figure 2.11, which depicts hourly earnings by percentile, this assumption is still reasonable given the latest data.

2.96 Figure 2.21 shows the latest estimates of the wage bill impact of the October 2004 upratings. We estimate that the direct impact of the October 2004 upratings increased the total adult wage bill by between 0.05 and 0.07 per cent and the 18-21 year old wage bill by between 0.18 and 0.24 per cent. Taking account of differentials this rises to 0.06 to 0.08 per cent for adults and 0.2 to 0.26 per cent for youths.

'For service sector firms in general rates of return have remained very high. In 2004 the average net return on capital for public corporations classified to the service sector was 15.5 per cent. There has been no significant difference in average profitability comparing the five years 1999-2004 with the previous five years. By international standards these returns are very high.'

TUC evidence

Figure 2.21

Estimated Impact on Wage Bills of the 2004 Minimum Wage Upratings, April 2004

Source: LPC calculations based on ASHE 2004, with supplementary information.

2.97 Comparing our estimates with those in the fourth report (2003), we now estimate that the direct effect of the October 2004 upratings was to increase the aggregate wage bill by between 0.06 and 0.07 per cent, compared with 0.05 to 0.09 per cent estimated in our fourth report (2003). Taking account of the impact on differentials raises the aggregate wage bill estimate to 0.06 to 0.08 per cent compared with the estimate of 0.09 to 0.13 per cent presented in the fourth report (2003).

2.98 Figure 2.22 looks at the impact of the 2004 minimum wage upratings on the wage bills in low-paying sectors. We can see that there are larger impacts on these sectors than on the economy as a whole. The largest impacts, in terms of percentage increase in the wage bill, are in hairdressing, hospitality and cleaning. The largest monetary impacts, however, are in the retail and hospitality sectors.

'Unlike infant or growth industries, where there is a great deal of scope for increased efficiency and competitiveness, retail is a mature industry, and it is a constant challenge for retailers to increase their levels of competitiveness.'

BRC evidence

Figure 2.22

Estimated Impact on Wage Bills of the 2004 Minimum Wage Upratings on the Low-paying Sectors, April 2004

Source: LPC calculations based on ASHE 2004, with supplementary information.

'Employers have often argued they are unable to increase prices to offset high labour costs. However, prices charged by "hairdressing and personal grooming establishments" went up by 4.5 per cent in the twelve months to August 2004 while prices charged by hotels and restaurants increased on average by 2.9 per cent compared with the overall increase in the index of 1.3 per cent (all figures Consumer Price Index).'

TUC evidence

Profits, Productivity and Prices

2.99 In our analysis above, we found that the minimum wage has had little effect, at the macroeconomic level, on employment or hours of work. This section considers whether the effect of the minimum wage might be felt instead through a fall in profits or an increase in prices.

2.100 First, we analyse the impact of the minimum wage on profits at a macroeconomic level. Second, we analyse whether there is any tendency for profit margins in the low-paying sectors to be more affected than those not exposed to changes in the minimum wage. Third, we look at the impact of the minimum wage on productivity and, finally, in this section we consider whether any price effects arise from upratings to the minimum wage.

'Market conditions in the sectors most affected by the NMW have meant there has been little, if any, scope to raise prices in response to higher labour costs.'

CBI evidence

Profits in the Macroeconomy

2.101 Fluctuations in the share of profits in gross domestic product (GDP), and in profit margins, are an important aspect of overall macroeconomic performance. Profits are the source of retained earnings by companies, which make up a major source of finance for investment spending. A higher rate of profit tends to be closely related to higher levels of investment spending on the modernisation and expansion of the capital stock. In turn, this enables higher levels of productivity, rising living standards and growth in the level of employment.

2.102 Overall, it appears that the profitability of the whole economy is currently at a healthy level. According to the Bank of England (2004) '...higher profits and ample corporate liquidity point to continued healthy growth in capital spending by business'. Further, the Bank of England goes on to note that, having been negative for extended periods since 1987, the financial balance of private non-financial corporations has remained in positive territory for the past two years.

2.103 This largely positive conclusion is borne out by Figure 2.23, which shows the long-term trend in the measure used by the Bank of England - the gross operating surplus of non-financial corporations as a percentage of private sector GDP.

Figure 2.23

Gross Operating Surplus of Non-financial Corporations as a Percentage of Private Sector GDP, 1956-2004

Source: ONS, current prices, not seasonally adjusted, 1956-2004.

Note: Private sector GDP is approximated by subtracting General Government Final Expenditure from Gross Domestic Product.

2.104 On this measure, the share of profits fell from the mid-1960s to the mid-1970s, but then staged a recovery up until the mid-1980s. Since the mid-1980s, the ratio has essentially gone sideways, fluctuating with the ebbs and flows of the business cycle. More recently, the data indicate that profits as a share of GDP reached a peak of 26.7 per cent in the first quarter of 1997, then fell to a low of 22 per cent in the first quarter of 2002 before recovering from the second quarter of 2003 onwards.

2.105 These movements in the profits share depicted above appear consistent with cyclical fluctuations such as those encountered in normal business cycles, and do not suggest any sustained deviation from the range that has been established over the last 20 years.

2.106 Some have suggested that, should the economy continue to grow at an above trend rate, a downturn in profits might result from renewed wage inflation as the labour market tightens. So far however, as noted above, there is no sign of increasing wage inflation. And such an effect could be offset if tight labour markets were accompanied by productivity growth.

2.107 The interaction between productivity growth and unit labour costs is depicted in Figure 2.24 below. According to the Bank of England (2004), productivity growth 'together with relatively subdued earnings growth means that annual growth in private sector unit wage costs slowed to less than 1 per cent in the second quarter of 2004. So currently, there is little near-term pressure from wage costs on CPI inflation.' Equally, there will be no macroeconomic tendency for profits to be squeezed by rising wage costs.

Figure 2.24

Private Sector Labour Productivity and Unit Wage Costs, 1998-2004

Source: ONS, Bank of England calculations, 1998-2004.

Notes:

1. Private sector labour productivity is private sector output divided by private sector workforce jobs. Private sector is defined as the whole economy less the public administration, education, health and social work sectors. The workforce jobs series has been adjusted so that it corresponds to calendar-year quarters. This measure of productivity is based on output per job rather than output per hour.

2. Private sector unit wage costs are private sector AEI (including bonuses) divided by private sector labour productivity.

2.108 Although the share of profits in private GDP is illuminating, it is not the measure that business people would use in gauging the success of an enterprise. Instead, they would typically focus on the rate of return on capital employed. ONS publishes rate of return data, both gross and net, for private non-financial corporations excluding UK Continental Shelf companies and it is these data to which we turn next.

Figure 2.25

Gross and Net Rates of Return on Capital Employed, All Private Non-financial Corporations Excluding UK Continental Shelf Companies, 1989-2004

Source: ONS, seasonally adjusted, 1989-2004.

2.109 Drawing on ONS quarterly data on rates of return since 1989, Figure 2.25 shows that the 1990/91 business cycle recession gave rise to a much more severe downturn in the rate of return than has occurred during the recent period, when the minimum wage was in operation.

2.110 Overall, we conclude that there is no evidence to suggest that the introduction and the upratings of the minimum wage have so far had any measurable effect on the profitability of UK companies in aggregate.

Profits at a Sector Level

2.111 Even if profits at the level of the whole economy have not been influenced by the minimum wage, there could be sectoral effects. For instance, there could be low-paying sectors in which it was difficult to achieve productivity increases or to increase prices.

2.112 Unfortunately, it is extremely difficult to analyse profitability trends in specific sub-sectors. In general, the service sectors of the economy (which include the specific sectors which employ the vast majority of low-paid workers) enjoy higher rates of return than manufacturing, but this is solely because they are less capital intensive (on conventional accounting measures of capital). And while the service sectors in total are, in the third quarter of 2004 according to ONS data, earning returns of 15 per cent, a little below the 2003 average of 15.7 per cent, these data are still too aggregated to allow any conclusions about minimum wages in specific sectors.

2.113 Overall, therefore, an analysis of aggregate data, both at the whole economy and at sectoral level, does not allow a firm conclusion. We have no reason to believe that profits have been reduced by the minimum wage, at sectoral level let alone national level, but it is impossible to conclude definitely that no profit squeeze has occurred. We have therefore supplemented our analysis of the available aggregate data with attempts to investigate individual company effects.

Commissioned Research on Profits and Margins

2.114 There is by now a large body of work examining the impact of the minimum wage on employment, focusing particularly on the question as to whether or not minimum wages price workers out of jobs. Since substantial employment effects have not been found, the question arises as to how firms are able to sustain the higher wage costs induced by minimum wages. If employment effects are small, then something else has to give. It may be that the minimum wage eats into profit margins, or prompts firms into raising prices. This is a significantly under-researched area. We therefore commissioned Draca, Machin, and Van Reenen (2005) to carry out empirical work in this area.

2.115 The researchers compared profitability and prices in low wage firms and industries before and after the introduction of the minimum wage compared with higher wage firms and industries. They found that wage growth in the low wage firms in low pay industries after the introduction of the minimum wage was 9.2 per cent higher than in the comparison group. In turn, the introduction of the minimum wage was associated with a fall in profit margins in the low wage firms and an increase in profit margins at the higher wage firms. Overall, profit margins for the most affected firms fell by a statistically significant 4.9 per cent compared with higher wage firms. Draca, Machin and Van Reenen therefore concluded that profitability fell in firms that were more affected by the introduction of the minimum wage.

2.116 This margin squeeze in low-wage firms does not, however, seem to have been sufficiently large as to force firms out of business. While there was a slight increase in the exit rate of firms from the experimental group versus the control group over the period, the difference was not statistically significant. Draca, Machin and Van Reenen concluded therefore that 'it is hard to detect any evidence that the minimum wage raised wage costs so much as to force low wage firms out of business'. This is consistent with the findings of other research that the minimum wage has had no significant adverse employment effects.

Productivity

2.117 As discussed above, and highlighted in Figure 2.24, labour productivity at the macroeconomic level has been growing since 2001. It has primarily been driven by factors other than the minimum wage. We commissioned some research to look at the impact of the minimum wage on productivity. Galindo-Rueda and Pereira (2004) found that in the service sector there was evidence of a positive one-off effect on labour productivity following the introduction of the minimum wage, however, they found no significant impact on labour productivity in the manufacturing sector.

Prices

2.118 As for price effects, the Draca, Machin and Van Reenen (2005) research could find only minimal price effects, concentrated in particular in the canteen and catering sector. But they also noted the severe methodological difficulties involved in researching this area, and it is possible that there are price effects which it is impossible to discern from this analysis.

Business Start-Ups and Failures

2.119 Another way of looking for the impact of the minimum wage would be to look at the levels and changes in both business start-ups and business failures. Arguably, an increase in the minimum wage might make it less attractive to start a business (for example by forcing wages higher). Alternatively, increases in the minimum wage could squeeze profits of existing firms leading to an increased number of business failures.

2.120 Figure 2.26 shows that there has been an increase in the number of VAT registered businesses in every year since 1995. During 2003 there were almost 190,000 registrations, but fewer than 175,000 de-registrations, leading to an increase of 15,500 in the stock of UK businesses. The Figure also shows that the introduction of the minimum wage has had little adverse impact on the number of businesses registered in the low-paying sectors. Indeed, despite the large upratings in the minimum wage in October 2003, the number of businesses in the low-paying sectors increased during 2003.

Figure 2.26

Net Change in the Stock of VAT Registered Enterprises in the UK, Thousands, 1995-2004

Source: Small Business Service (2004).

Note: Stock is at 1 January of the given year.

2.121 Figure 2.26 also shows that there was a fall in the stock of low-paying sector businesses in 1999. It was not surprising, therefore, that Galindo-Rueda and Pereira (2004) found that employment and business creation became slower in areas of the country where the minimum wage had greater effect, although this was partly explained by a trend preceding the introduction of the minimum wage. In their study on profits and margins, Draca, Machin and Van Reenen (2005) were unable to find any evidence that the minimum wage had caused low-paying firms to go out of business.