The evidence shows that the minimum wage has been a success. The economy has continued to generate new jobs, including in the main low-paying sectors, without any signs of an emergence of wage inflation. Many low-paid workers have benefited. While some firms continue to report difficulties in adjusting to the successive upratings of the minimum wage, the impact on aggregate and sectoral wage bills has been minimal.

Our formal and informal consultations with employers, however, revealed high levels of concern about the effect of the last two upratings and about the potential impact of further significant increases. And the available macroeconomic data do not yet allow an appraisal of the full effects of the uprating of the minimum wage to £4.85 in October 2004. Our assessment therefore needs to balance the available macro data with the input from consultations.

Most of the interested parties accepted the case for an uprating, but there was no consensus. The range of opinions varied from below to substantially above the predicted growth in average earnings.

Balancing these considerations, we believe that there is a strong case for continuing along the path of uprating the minimum wage outlined in the fourth report (2003), with a further increase relative to average earnings over the next two years. But, in the light of the level of employer concern, we judge it appropriate to proceed with caution. For that reason we are recommending that the increase over two years should be above predicted average earnings, but not substantially so. We also consider that the upratings should be phased so that the increase in the first year is modest, allowing employers further time to adjust to the October 2004 uprating. We recommend that the adult rate of the minimum wage should be increased to £5.05 in October 2005 and further increased to £5.35 in October 2006. We recommend that the 2006 uprating be subject to review, both to check that the macroeconomic conditions continue to make it appropriate, and in the light of the implementation of age discrimination legislation as outlined below.

The Government has set out its intention of legislating, during the course of the next Parliament, to ensure that the eight bank holidays count as paid leave in addition to the 20 days of paid leave (for a typical full-time worker) which the law currently requires. In the vast majority of cases this change will make no difference, since about 92 per cent of full-time workers already enjoy at least 20 days paid annual holiday excluding the eight bank holidays. And the overall hourly wage bill impact of the change seems unlikely to exceed 0.4 per cent. But those specific companies which currently do not allow paid bank holidays in addition to the 20 days could face hourly wage bill increases of 3.2 per cent and such companies are likely to be concentrated in low-paying sectors.

We do not believe therefore that the proposed change will have an impact sufficiently large or sufficiently widespread as to make further upratings of the minimum wage inappropriate, but we note that the pace of introduction will determine the severity of adjustment difficulties in specific firms. The timing of the implementation is presently uncertain and dependent both upon Government intentions and the Parliamentary schedule. We have based our recommendations on the assumption that the full impact will not occur within the two years covered by this report. We will take the additional costs into account in future years.

While workers in other age groups have seen their position in the labour market improve, the position of young people has remained more or less static. Our ability to increase the adult rate by slightly more than average earnings depends on the continued existence of the youth Development Rate and the 16-17 year old rate. We believe that the application of the adult rate to younger people would damage their employment prospects. And the existence of separate rates for young people is fully consistent with the Equal Treatment Directive.

Our recommendation of a figure of £5.35 for the adult rate in October 2006 therefore depends on the assumption that the forthcoming UK implementation of the Equal Treatment Directive will continue to allow the straightforward use by employers of the lower rates for younger people. The Commission therefore recommends that it should review its recommendation for October 2006 in February 2006 and confirm it if the implementation of the legislation has been designed to achieve this.

The Commission believes, however, that this reinforcement of the principle of lower rates for younger people should be combined with a change in the upper age limit for the youth Development Rate from the 22nd to the 21st birthday.

We recommend that the youth Development Rate be increased to £4.25 in October 2005 and to £4.45 in October 2006. We recommend an increase slightly lower than the adult rate (and lower than the forecast increase in average earnings) recognising that young people have done less well in the labour market and in the expectation that the Government will recognise the case for extending the adult rate to 21 year olds.

In our fourth report we said that we believed that there was a case for increasing the effective level of the minimum wage. The increase we have recommended over the next two years will again exceed the predicted growth of average earnings. We have, however, kept the adjustment above average earnings small, and concentrated it in the second year to allow business time fully to absorb the impact of the increases.

However, it remains our view that some further increases relative to average earnings will be required in subsequent years to bring the minimum wage to an appropriate long-term level.

We make no recommendations with regard to the 16-17 year old rate. We propose instead that the Government invite us to review the operation of the 16-17 year old rate in 2005 and report in February 2006 with recommendations for any subsequent increase suitably adjusted to take account of the absence of any uprating in 2005.

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Introduction

7.1 In arriving at our recommendations we have considered three main factors: our assessment of the impact of the minimum wage so far (set out in detail in Chapters 2 to 5); an assessment of the prospects for the economy over the coming period; and the views expressed by interested parties. This Chapter covers each of these three factors in turn before setting out our recommendations for minimum wage rates for adults and young people for October 2005 and October 2006. It then sets out our assessment of the likely impact of the recommended rates on the number of beneficiaries, the wage bill, and household income. Finally, we reflect on the cycle of our reviews in the light of comments received during consultation.

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The Impact of the Minimum Wage So Far

7.2 The economic evidence shows that overall employment levels have continued to strengthen since the introduction of the National Minimum Wage. There has been no evidence of adverse effects on inflation but, inevitably, the minimum wage has created some adjustment difficulties for some firms. As for profits, the macroeconomic data do not support a conclusion that the minimum wage has affected the overall level of profitability in the economy, but equally it is not possible to conclude from the data that there has definitely not been any effect. One study we commissioned did find an impact on the level of profitability of firms that predominantly employ workers paid at or around the minimum wage. But the evidence suggests the impact has been moderate.

7.3 The impact on wage bills remains small. Our latest estimates of the effect of the October 2004 upratings show a range of increases in the overall UK wage bill, depending on the assumptions used, of between 0.06 per cent and 0.08 per cent.

7.4 While the absence of adverse effects is welcome, it is also important that a significant number of workers benefit from the minimum wage. Throughout the life of this Commission, the number of beneficiaries has turned out to be smaller than originally forecast. This issue is explored more fully in Chapter 2. Our latest estimates, based on the provisional Annual Survey of Hours and Earnings (ASHE) April 2004 data, are that about one million adult workers, or 4.4 per cent of the adult workforce, received wage increases between April 2004 and October 2004 as a result of the minimum wage uprating to £4.85 in October 2004. The equivalent estimate for the October 2003 uprating to £4.50, indicates that 0.9 million or 3.8 per cent of the adult workforce were direct beneficiaries in the six months before the uprating. These numbers are similar to those we have observed following previous upratings. As noted in Chapter 2 however, this 'undershoot' may largely reflect methodological difficulties in estimating the number of beneficiaries once the minimum wage has been in place for several years.

7.5 The combination of these considerations, however, supports the Commission's judgements (in our fourth report) that it was appropriate to increase the effective level of the minimum wage over the last two years, and that this increase - bringing benefit to more workers - has been achieved without adverse economic consequences.

7.6 As we saw in Chapter 5, however, labour market data suggest that young people have fared slightly less well. While the employment and activity levels of other groups in the economy have strengthened, participation in the labour market by those aged 18-21 has remained more or less static. There is little evidence to suggest that the minimum wage is responsible for the relative weakness in the labour market of this group of workers, since around 85 per cent of all jobs held by 18-21 year olds pay at or above the adult minimum wage. But, as noted in previous reports, there remain grounds for caution on youth rates.

7.7 Overall, therefore, the evidence so far suggests that the adult rate is not at a level which is causing any undesirable macroeconomic consequences and that it should be uprated at least in line with the forecast growth in average earnings. At the same time, the pace of any adjustment needs to reflect prospects for the economy. In the next section, therefore, we consider recent economic forecasts and trends in prices, earnings, and pay settlements.

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The Economy

7.8 The economic outlook partly determines the minimum wage that firms can afford without detrimental impacts on employment prospects or on inflation. Forecasts of price inflation and earnings growth are also used to estimate future wage bill costs and to gauge the likely number of beneficiaries (the 'coverage') of future minimum wage rates. This section therefore examines aggregate forecasts before turning to detailed consideration of how price, earnings and pay settlement trends influence our decisions.

Forecasts

7.9 Economic performance has been strong since our fourth report (2003) - indeed in 2004 the pace of economic growth exceeded the expectations of all but the more optimistic forecasters. The inflation rate has been well contained. And employment levels, as discussed in Chapter 2, have remained at record levels.

7.10 Looking forward, Table 7.1 shows that the consensus of latest forecasts for the UK economy suggests a modest slowdown in Gross Domestic Product (GDP) growth as the economy moves from a period of above trend growth towards trend growth of some 2.5 per cent. At the same time, inflation as measured by the Consumer Price Index (CPI) is predicted to remain below the Bank of England's target of 2.0 per cent, at least until 2007. Average earnings growth is forecast to be some 4.5 per cent, which is compatible with low growth in unit labour costs if productivity grows in line with trend.

Table 7.1 Independent Forecasts of GDP Growth, Inflation and Average Earnings

Source: HM Treasury (2005).

7.11 There are risks in any forecast. But if anything the risks to the macroeconomic outlook look less pronounced in February 2005 than when we produced our fourth report with its recommendations for rises in October 2003 and October 2004.

7.12 Consensus forecasts and assessments of risk therefore suggest that the economy will be able to absorb further increases in the minimum wage at least in line with anticipated growth in average earnings. The one note of caution that must be sounded is that the available data do not yet allow a full appraisal of the impact of the October 2004 increase, which at 7.8 per cent was significant in real terms. While our judgement from available data is that it is probable that the increase has been absorbed without adverse effect, the lack of certainty argues for some caution looking forward.

Prices

7.13 Since its introduction in April 1999, the minimum wage has more than kept up with the cost of living. If the adult minimum wage had been increased in line with the RPIX price index¹ since introduction, its value would have been £4.06 in October 2004, significantly below the actual level of £4.85. But a minimum wage that increased only in line with prices would rapidly lose its value as a wage floor. The lowest paid would not share in the overall rise in earnings and prosperity. While prospects for inflation need to be part of our economic assessment, increasing the minimum wage only in line with prices would be a recipe for making the minimum wage increasingly irrelevant over time.

Earnings

7.14 Increasing the minimum wage in line with average earnings implies an increase above the rate of inflation, and keeps the minimum wage in line with the increase in the general level of prosperity in the country. In the year to December 2004, average earnings as measured by the Average Earnings Index (AEI) increased by 4.3 per cent including bonuses and 4.5 per cent excluding bonuses. The data are consistent with an underlying pace of increase of about 4.5 per cent.

¹ RPIX measures price inflation excluding mortgage interest costs.

7.15 If the adult minimum wage had, since its introduction, increased in line with average earnings, its value in October 2004 would have been £4.50 as opposed to the £4.85 then introduced. This outcome reflects the fact that over the last two years the growth in the minimum wage has outpaced increases in average earnings. If the minimum wage were to be increased by the same pace as average earnings between October 2004 and October 2006, its value would rise to £5.07 in October 2005 and £5.30 in October 2006.

7.16 Uprating the initial level of the youth Development Rate (£3.00) by average earnings would have led to a rate of £3.75 by October 2004, showing that at its current level of £4.10 the youth Development Rate has increased faster than earnings. Projecting the current rate forward by forecast average earnings would give rise to rates of £4.28 and £4.48 in October 2005 and October 2006 respectively.

7.17 These earnings-uprated projections provide a benchmark against which we can judge how the minimum wage is progressing relative to earnings overall. We concluded, in the light of our analysis of the impact of the minimum wage, that a further modest increase in the effective level of the minimum wage would not do significant harm to the overall economy and would preserve and increase slightly the number of beneficiaries.

Pay Settlements

7.18 The level of pay awards provides an important indicator of general movements in pay. Incomes Data Services (2005b) report that the median pay settlement was 3.1 per cent in the year to October 2004. Other data, such as those from Industrial Relations Services (2005), show a similarly constant pattern around 3 per cent. Pay settlements are stable, display no discernible tendency to accelerate, and therefore do not portend any damaging wage-price spiral. All remain consistently below the growth in average earnings; this is because negotiated settlements generally exclude merit awards, promotion, and other pay drift effects.

7.19 That pay settlement data and growth in average earnings display such a high level of stability has been taken by some to indicate that the labour market is not as tight as it appears. One likely explanation is that the current level of migration provides employers with a ready stream of willing and able workers, which enables employers to fill crucial gaps in their labour forces without being forced to resort to higher wages in order to recruit workers.

'Having looked at the evidence to date and the outlook for the economy and the labour market as a whole, we believe a further significant increase in the NMW above the expected rise in average earnings is both credible and realistic.'

TUC evidence

7.20 The level of pay settlements is consistent with the overall picture of subdued inflation, with no significant inflationary pressures emanating from the labour market.

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The Views of Interested Parties

7.21 All the macroeconomic data referred to above suggest that current economic circumstances are benign and that it is possible to increase the effective level of the minimum wage. However, in reaching our conclusions about the scope for further increases in the minimum wage, we also took careful account of the views of a wide range of those most affected, including employer representatives, trade unions, youth organisations and the not-for-profit sector. These face-to-face meetings sometimes gave us a perspective on an issue that was not readily visible in the available aggregate or macroeconomic data.

7.22 The vast majority of employer organisations accepted that the minimum wage should be uprated, but many preferred future increases to be limited to price inflation. A smaller number proposed a link with average earnings.

'Against the backdrop of a continuing deflationary climate in the High Street, companies just cannot continue to live with successive disproportionate increases that have been more than double the prevailing level of pay settlements in the sector. We would strongly urge that there should be no increase in the minimum wage in 2005, in order to give companies time to adjust to previous years' increases.'

BATC evidence

7.23 In contrast, trade unions and other workers' organisations argued that further substantial increases in the minimum wage could be achieved with no ill effects on the economy or on employment. Among those we met were some who argued for a significant increase in the value of the minimum wage - with a few suggesting we should adopt the concept of a 'living wage' set at a far higher level.

7.24 In calling for modest future increases, employers drew attention to the two sizeable, above inflation increases in the minimum wage which took effect in October 2003 and 2004 and expressed doubts about the ability of the economy as a whole to withstand further increases on a similar scale. The British Retail Consortium pointed to the growing concern among large retailers about the impact of the minimum wage. They argued that the minimum wage had reached a 'tipping point' with the last two increases and warned of future job losses in the sector as a direct result. A quarter of retailers responding to their survey were already considering reducing jobs as a result of the October 2004 increase to £4.85.

7.25 The CBI argued that the level of corporate profitability appeared to have peaked in the present cycle at a lower percentage of GDP than in previous cycles, and that a squeeze on profits, combined with uncertainty about the economic outlook, was reducing investment in fixed capital and equipment, with potentially harmful consequences for the UK's long-term growth prospects. It was also concerned about increased business costs as a result of new regulation, including the rise in employer National Insurance Contributions. The CBI concluded that, as a result, future increases in the minimum wage would be much less affordable and called for a 'pause year' in 2005.

'In some cases staffing levels have already been affected by the NMW, with 16 per cent of retailers saying they were unable to maintain their staff levels when the NMW was £4.50.... At £4.85, 25 per cent of retailers are unable to maintain their current employee level and this increases to 44 per cent at £5.20.'

British Retail Consortium evidence

7.26 The British Chambers of Commerce was concerned that further increases in the minimum wage above average earnings 'could start to have a detrimental impact on staffing levels and competitiveness'. Like a number of employer representatives, the Business Services Association also commented that differentials had been squeezed and the Cleaning and Support Services Association was similarly concerned that this had had a negative impact on recruitment. One of the concerns commonly expressed was that, as the wages of the low-paid rise to the level of those above, it becomes harder for firms to provide incentives to employees to assume positions of greater responsibility.

7.27 Trade unions and other workers' organisations, however, emphasised the success of the minimum wage to date in reducing exploitation and raising the earnings of the lowest-paid workers without any apparent negative effects. They noted that employment had increased to unprecedented levels; inflation was stable and argued for further increases in the minimum wage above average earnings. The Trades Union Congress (TUC) called for a rise to at least £5.35 in October 2005, moving towards £6.00 by October 2006. Some unions wanted more, with the GMB calling for an increase to £6.00 from October 2005 and Unison seeking £6.50 by October 2006. A number of respondents also argued that substantial increases were required to raise the minimum wage from a wages floor to a living wage (reducing dependency on in-work benefits such as the Working Tax Credit) and to tackle the gender pay gap.

'By reducing the costs of chronic staff turnover, and pushing employers to invest in training and productivity measures, a NMW of £6 an hour will start to address the low pay, low skills, low productivity vicious circle which traps [low-paying] sectors.'

GMB evidence

7.28 A number of respondents called for the minimum wage to take account of regional differences in the cost of living and of local economic circumstances. The British Apparel and Textiles Confederation (BATC) said that the Commission should consider a regional or sectoral minimum wage and the Federation of Small Businesses believed there was a strong case for a regional minimum wage. The Low Pay Commission's remit, however, is to make recommendations for a National Minimum Wage only, not a wage that varies from region to region. Nor are we mandated to recommend a 'living wage'. Rather our aim is to set a minimum wage that establishes an important floor. Moreover, alongside other government policies, it makes a significant difference to low incomes, but does so in ways that do not cause economic harm. The total combined impact of the minimum wage and the benefits system is considered below in the section The Impact on Low Incomes.

'The CBI accepts that the National Minimum Wage should increase as economic circumstances allow so that it does not wither on the vine. However, if negative effects of the NMW are to be avoided, any uprating must take account of the competitiveness of the overall UK economy and that of individual firms.'

CBI evidence

7.29 Submissions from the trade unions and workers' organisations consistently argued that the adult rate of the minimum wage should apply from the age of 18 and that a lower youth rate was discriminatory. Youth organisations feared that young people were being exploited in the workplace and that too low a rate could force those in education to work longer hours to support their studies. A smaller number of respondents proposed a flat rate from 16, but there was generally an agreement that a lower rate for 16-17 year olds was necessary.

7.30 Employer representatives were broadly supportive of maintaining the current differential between the adult rate and the youth Development Rate, although the British Hospitality Association urged caution to avoid pricing the 18-21 age group out of the market place. Business representatives also tended to agree that the 16-17 year old rate should not increase, or that any increase should be small in 2005, until the impact of the £3.00 rate introduced in October 2004 could be fully assessed.

7.31 A common theme expressed by many business representatives and by some unions was the need for greater predictability of future rates. However opinion was divided on the question of whether an automatic indexing process should determine future minimum wage upratings, or whether flexibility was required to respond to changing economic circumstances.

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The Recommended Rates

7.32 Our recommendations have taken account of both quantitative and qualitative sources of data, covering both economic and sectoral effects. Our aim is to have a minimum wage that helps as many low-paid employees as possible without any significant adverse impacts on inflation or employment.

7.33 Quantitative analysis of the impact of the minimum wage so far shows that it has not had significant inflationary effects nor has it destroyed jobs at either the overall or sectoral level. Its wage bill impact has been low, lower than originally anticipated, and well below levels which might create the danger of an inflationary spiral. This suggests that, notwithstanding the significant real increase over the past two years, there is scope for a further increase in the effective level of the minimum wage over the next two years.

'An equal minimum wage would make a difference to many more young people's lives; protecting all our most vulnerable workers and giving them a fair, equal and legitimate position in the workplace.... An equal minimum wage would also help relieve the increasing financial pressures for younger people....'

Coalition of Youth Organisations' evidence

7.34 Economic forecasts suggest that such an increase would take place against the backdrop of economic growth close to trend, and an inflation rate below the Bank of England's target of 2 per cent. And the risks to this outlook seem less severe than when we last made recommendations for the adult rate in February 2003.

7.35 However, we note business concerns about the impact on differentials. We have therefore recommended an uprating for October 2005 slightly below the projected growth in average earnings. At the same time, given that there is a general desire among employers to move away from alternating small and large adjustments, we have deliberately not proposed an award too heavily skewed towards one year or the other.

7.36 We recommend that the adult rate of the minimum wage should be increased to £5.05 in October 2005 and that it should be further increased to £5.35 in October 2006. We recommend that the 2006 uprating be subject to review in February 2006, both to check that the macroeconomic conditions continue to make it appropriate, and in the light of the implementation of age discrimination legislation as outlined below.

7.37 Our recommendations envisage increases in the minimum wage in October 2005 and October 2006 which, taken together, imply an increase in the minimum wage above the projected increase in average earnings. In the first year, the recommended increase in the adult rate of 4.1 per cent is slightly below the projected growth in average earnings, but taken together the two increases amount to 10.3 per cent, 1.1 percentage points greater than the projected 9.2 per cent compound increase in average earnings.

7.38 For the youth Development Rate we recommend slightly lower increases than those proposed for the adult minimum wage, with a 3.7 per cent increase in October 2005 and a total of 8.5 per cent over two years. This reflects the need for some caution in the light of mildly adverse trends in youth labour markets. We recommend the Youth Development Rate should be £4.25 in October 2005 and £4.45 in October 2006. This latter recommendation is however strongly tied to our firmly held conviction that 21 year olds should receive the adult rate. Should 21 year olds continue to be paid the youth rate we would probably recommend that the youth Development Rate be increased proportionately in line with the increase in the adult rate.

7.39 Our ability to increase the adult rate by slightly more than average earnings depends on the continued existence of lower rates for younger people (i.e. the youth Development Rate and the 16-17 year old rate). Evidence suggests that the application of the adult rate to younger people would have adverse employment consequences, given the distinctive features of the labour market for young people. Separate rates for young people are also fully consistent with the Equal Treatment Directive (2000/78/EC), which specifies that different remuneration rates for young people on grounds of age shall not constitute discrimination if, within the context of national law, they are objectively and reasonably justified by a legitimate aim (including employment policy).

7.40 Our recommendation of a figure of £5.35 for the adult rate in October 2006 therefore depends on the assumption that the implementation of this anti-age discrimination legislation will continue to allow the straightforward use by employers of the flexibility which the existence of the lower rates for younger people is intended to allow. The Commission therefore recommends that it should review its recommendation for October 2006 in February 2006 and confirm it if the implementation of the legislation has been designed to achieve this.

7.41 As the minimum hourly rate for 16-17 year olds was introduced for the first time in October 2004, the evidence on which to base a judgement is not yet available. Accordingly, we make no recommendations at this time with regard to the 16-17 year old rate. We recommend instead that the Government invite us to review the operation of the 16-17 rate in 2005 and report in February 2006 with recommendations suitably adjusted to take account of the absence of any uprating in 2005.

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The Impact of Our Recommendations

Coverage - the Number of Beneficiaries

7.42 Since the recommended adult rates for October 2006 will represent an increase from October 2004 slightly above average earnings, this two-year uprating is likely to produce an increase in coverage.

7.43 To estimate coverage figures we need to assume how the wages of the lowest paid would increase in the absence of the minimum wage. Our preferred calculations are based on the assumption that the wages of the low paid would have increased in line with average earnings.

7.44 Assuming that, from October 2005, 21 year olds would be entitled to the adult minimum wage and if low wages were to increase in line with average earnings, we estimate that at the new rate of £5.35 in 2006, the number of adult beneficiaries (aged 21 and above) would be about 1.2 million or 5.3 per cent of the labour force. If we assume instead that the wages of the low paid would merely have matched price inflation, a greater number of workers would turn out to be beneficiaries - about 2 million or 8.5 per cent of the adult workforce. We believe that the average earnings assumption is the most credible. On this basis we estimate that the new rate for the minimum wage will achieve slightly higher coverage levels than those achieved by the £4.85 uprating in October 2004.

7.45 Given the less certain position of young workers in the labour market, we have opted to increase the youth Development Rate by a smaller percentage than the adult minimum wage, by 3.7 per cent in October 2005, and an increase over the two years of 8.5 per cent to October 2006. On the basis of the assumption that young people's wages would otherwise rise with average earnings, we estimate that about 100,000 young workers (aged 18-20) would be beneficiaries of the new youth Development Rate in October 2005; this equals about 7.7 per cent of young workers.

7.46 We should also remember that roughly 85 per cent of young workers are paid at least the adult minimum wage. Many of these will therefore be beneficiaries of the proposed uprating of the adult minimum wage, which is larger in percentage terms than the increase in the youth Development Rate as well as the projected growth in average earnings.

7.47 Taking the increase through to October 2006, and assuming again that, in the absence of an increase in the minimum wage, the increase in youth wages would have matched the growth in average earnings, we calculate that there would be a similar number of beneficiaries to the October 2005 uprating.

7.48 Overall, we estimate, based on the proposed new rates for October 2006, that the total number of beneficiaries would be about 1.3 million if wages of the low paid were to increase by the forecasted growth in average earnings over the two years, or around 2.1 million if, instead of increasing in line with average earnings, the low paid would otherwise have received increases in line with prices.

Position Relative to Average Earnings

7.49 In previous reports we have commented on the relationship between the minimum wage and average earnings as a way of measuring the 'bite' of the minimum wage. ONS has recently replaced the mean with the median as its headline measure of average earnings, and this is the measure that we use here. It is preferred over the mean for earnings data as it is less influenced by extreme values, which occur at the upper end of the distribution. We considered the relationship of the minimum wage to median earnings in our fourth report (2003).

7.50 In April 2004, according to ASHE, the median gross hourly earnings (excluding overtime) of all employees (full-time and part-time) were £9.21. Uprating that figure by the growth in average earnings actual and predicted (including bonuses) yields a basis for comparison with the minimum wage. The figure arrived at in this fashion is £10.28 for October 2006. The new recommended adult rate of the minimum wage will thus be about 52 per cent of forecast median earnings, or slightly more than half median earnings. If instead of looking at the median earnings of all workers, we looked at those of full-time workers alone and compared the minimum wage with median full-time hourly earnings excluding overtime, the corresponding proportion would be 46 per cent.

7.51 Comparing this UK ratio for full-time employees with that of other countries we find the UK placed squarely in the middle of the existing range for the twelve OECD countries used as a basis of comparison - see Table A4.2 in Appendix 4. The new ratio would place the UK joint seventh in relation to other countries, behind Australia, France, New Zealand, Ireland, Belgium, and Greece, but substantially ahead of Spain, the United States, Japan and Canada. The position in the UK is roughly on a par with that in Holland.

Wage Bills

7.52 Assuming that wages would increase in line with the predicted rise in average earnings regardless of our proposals, the impact of our recommendations on the overall wage bill will be small. Over the two-year period, we recommend that the adult minimum wage should increase by 10.3 per cent compared with a predicted increase in average earnings of around 9 per cent. The impact will be smaller in the first year when, if our recommendation is accepted, the adult minimum wage will rise by 4.1 per cent - lower than the expected 4.5 per cent increase in average earnings. In October 2006, if the Government agrees, the adult minimum wage will increase by a further 5.9 per cent, compared with the forecast average earnings growth of 4.5 per cent.

7.53 There are two additional factors to take into account. As discussed in Chapter 2, some people are paid below the minimum wage. Assuming that all those earning less than the minimum wage receive increases that take them up to the recommended minimum wage in 2005 and 2006 would add a little more to the impact on the wage bill. Moreover, we are recommending that 21 year olds should be entitled to the adult minimum wage and this would lead to an increase in wages of more than 10.3 per cent for those affected. However, as around 92 per cent of working 21 year olds are already paid at least the adult rate, the impact will not be significant. Overall, we conclude that the direct impact of our recommended upratings on aggregate wage bills will be modest. Taking all of the above into account and using the earnings assumption we calculate that, compared with October 2005, the direct wage bill in October 2006 would increase by about 0.02 per cent as a result of the 2006 upratings. If differential impacts were included, the increase would be 0.04 per cent. Using the prices assumption, the increases are estimated to be 0.07 per cent and 0.09 per cent respectively.

7.54 The impact of the recommended upratings in 2005 and 2006 would not be even across the economy. As discussed in Chapter 2, the impact falls more heavily on small firms and the low-paying sectors. This will again be the case for the 2005 and 2006 upratings.

Bank Holidays

7.55 The Government asked us to consider the impact of legislating to ensure that bank holidays are not counted as part of a worker's annual statutory leave entitlement. At present, the Working Time Regulations 1998 (SI 1998/1833) provide that 'a worker is entitled to four weeks' annual leave in each leave year'. In general, employees work a five-day week, and thus would be entitled to 20 days annual paid leave. Part-time workers have a pro rata entitlement based on the number of hours worked. These regulations do not explicitly state that bank holidays are to be in addition to this entitlement, and some employers have counted them as forming part of the 20 day entitlement (or its pro rata part-time equivalent).

7.56 If no-one was presently entitled to paid leave on bank holidays, there would be an additional eight days of annual leave for which all employers would need to pay. Assuming that employees typically work a five-day week, this would be equivalent to a 3.2 per cent increase in their annual earnings. Thus the maximum possible increase to the wage bills of the total economy would be 3.2 per cent. However, most employees already enjoy this entitlement.

7.57 Table 7.2 below, drawing on information from the Labour Force Survey (LFS), shows that in Autumn 2003 around 83 per cent of the workforce were already receiving 20 days or more paid leave (not counting the eight bank holidays). Fewer than eight per cent of full-time employees were not receiving at least 20 days. Even half of all part-time workers got 20 days or more paid leave.

Table 7.2 Paid Leave Entitlement (Excluding Bank Holidays) for Working Age Employees by Hours, Autumn 2003

Source: LFS, September-November 2003.
Note: Figures may not sum to 100 due to rounding.

7.58 Due to the lack of adequate data, there are difficulties in determining the pro rata entitlement for part-time employees, but three-quarters of part-time workers received at least 10 days paid leave excluding bank holidays.

7.59 We estimate that, at most, the new entitlement would add 0.25 per cent to the total wage bill for full-time employees and 0.75 per cent to the total wage bill for part-time employees. We arrive at this figure by multiplying the maximum 3.2 per cent increase which applies to full-time workers benefiting by estimates of how many are affected and by how much. Overall, the impact would amount to, at most, an additional 0.4 per cent on aggregate wage bills.

7.60 Most full-time employees along with many part-timers are already getting this entitlement. The implication is that for the vast majority of employers the proposed legislation will have little or no impact. Conversely however, for a few employers the impact may be considerable.

7.61 Our main concern is the potential impact on low-paying sectors. Table 7.3 shows paid leave entitlement for those employees earning £4.50 or less an hour¹. In Autumn 2003 out of a total of around 950,000 full-time employees earning £4.50 and below, around a quarter (about 230,000) did not get 20 days paid holiday. However, around 90,000 of these had been with their employer for less than a year and so would only have been entitled to a lesser number.

Table 7.3 Paid Leave Entitlement (Excluding Bank Holidays) for Low-paid Working Age Employees by Hours, Autumn 2003

Source: LFS, Autumn 2003.
Notes:
1. Those earning £4.50 or less in Autumn 2003, when the adult minimum wage was £4.20 in September 2003
and £4.50 in October 2003.
2. Figures may not sum to 100 due to rounding.

7.62 Further, there were about one million part-time employees paid £4.50 or less in Autumn 2003. Of these part-time employees, about 41 per cent (410,000) received fewer than ten days paid leave. However, nearly half (195,000) had been with their employer for less than a year.

7.63 Overall, this suggests that no more than 230,000 low-paid full-time employees received less than their full paid leave entitlement and maybe 400,000 low-paid part-timers received fewer than 10 days paid leave.

7.64 On these figures, the annual cost of total compliance to employers of low-paid employees could add up to 1.1 per cent to their annual total wage bill. However, the impact would not be spread evenly; it would be nil for some employers, but higher (potentially up to 3.2 per cent) for others.

7.65 We do not believe, therefore, that the proposed change will have an impact so large or so widespread as to make further upratings of the minimum wage inappropriate, but we note that the pace of introduction will determine the severity of adjustment difficulties in specific firms. The timing of the implementation is presently uncertain and dependent both upon Government intentions and the Parliamentary schedule. We have based our recommendations on the assumption that the full impact will not occur within the two years covered by this report. We will take the additional costs into account in future years.

¹ The income data in the LFS are self-reported and many responses are proxy responses from other household members. Thus, care should be taken in interpreting estimates of the number of those working in low-paid jobs derived from the LFS. It should be noted that the adult minimum wage was uprated from £4.20 to £4.50 in October 2003. We use £4.50 or below as the measure of low pay in this analysis. According to the LFS, using the derived hourly wage variable, around one million full-time employees were paid £4.50 or below in Autumn 2003.

Public Sector

7.66 As we have noted in previous reports, agreements for public sector wage rates tend to be reached at levels above the minimum wage. Accordingly, the estimated effect of the new recommended rates on public sector wage bills is small.

7.67 We asked the Government to provide estimates of the impact on public expenditure of hypothetical 10 pence and 30 pence increases in the adult rate of the minimum wage. The estimated full-year savings for the Exchequer are shown in Table 7.4 below.

Table 7.4 Government Savings from an Increase in the Adult National Minimum Wage, £ million, 2005/06

Source: Department for Work and Pensions estimates based on 2002/03 Family Resources Survey data, uprated to 2005/06 and Inland Revenue estimates based on 2002/03 Family Resources Survey data, uprated to 2005/06.

7.68 Increasing the minimum wage in line with our recommendation for 2005 is therefore estimated to save around £225 million in a year. This figure is indicative only. The estimate assumes no behavioural response on the part of workers or employers and does not take into account the impact on corporation tax. It also excludes the cost to public sector wages and any higher prices for purchasing goods and services resulting from the minimum wage uprating, e.g. the price of contract cleaning may rise.

The Impact on Low Incomes

7.69 The National Minimum Wage is part of a wider Government strategy to make work pay and to improve the financial incentive for people to go out to work. It complements the tax and benefits system. For many of those earning the minimum wage, their overall household income will be substantially supplemented by tax credits and benefits.

7.70 In April 2003 the Government reformed the tax and benefits system, introducing the Working Tax Credit (WTC) and the Child Tax Credit. The WTC builds on the old Working Families Tax Credit and provides financial support on top of earnings, to improve incentives for households moving into work at low earnings. The 2004 Pre-Budget Report (HM Treasury, 2004c) provided details of minimum income guarantees for April 2005 as a result of the WTC and the £4.85 per hour adult rate of the minimum wage. These were:

• £258 a week for a family with one child and one earner working for 35 hours on the adult rate of the minimum wage;
• £198 a week for a single earner couple without children or a disability, aged 25 or over and working for 35 hours on the adult rate of the minimum wage.

7.71 In the first example shown, the £4.85 per hour adult rate of the minimum wage would thus be topped up to £7.37 per hour take-home pay once tax credits and benefits are taken into account. The second example equates to an hourly rate of £5.66.

7.72 Our recommendations for future rates of the minimum wage will further improve incentives to move into work. An important feature of the new tax credits is that any increase of less than £2,500 on the previous year's family income does not affect that year's tax credit assessment. This means that recipients do not see their tax credits reduced as soon as their income rises and therefore workers on the minimum wage will receive the full benefit of the increase until the end of the tax year, when their tax credit will be reassessed.

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Future Reviews

7.73 We noted earlier in this Chapter that some business representatives would favour a form of indexation to make future upratings more predictable. Other employers called for more notice of upratings and a few, particularly in the retail sector, suggested that they take effect in April each year. At present the Low Pay Commission conducts biennial reviews (normally published in March) for implementation in October of the same year and October of the following year. The British Retail Consortium (BRC) saw this as out of step with the financial year used by many companies, obliging them to adjust pay budgets (set at the start of the financial year) by means of a second pay review in October designed to ensure compliance with the minimum wage.

'The six months' notice (March to October) in year one is insufficient for many businesses which budget on, for example, a January to December basis.'

British Hospitality Association evidence

7.74 The BRC was also concerned that minimum wage upratings should be 'sensitive to changes in economic conditions' and take account of evidence on the impact of the most recent upratings, even if this reduced the time between the announcement of changes and their implementation. In contrast, the British Chambers of Commerce and the British Hospitality Association called for longer notice of upratings. The CBI commented that some firms would prefer announcements to be made in April for implementation in October the following year, thus giving 18 months notice. BUPA Care Services suggested that the Commission make recommendations for the next three years and the Independent Care Organisations Network recommended a rolling review programme. However, the Hairdressing Employers Association and the National Hairdressers' Federation were concerned that small firms found it difficult to keep abreast of new rules and regulations and called for 'no change to the architecture of the National Minimum Wage for a period of at least two years'.

7.75 These comments highlight some of the difficulties in determining the most appropriate timetable for the review cycle. While on the one hand some firms would like more notice of future upratings, there is also a need to make recommendations based on timely information on economic conditions. The current timetable for submitting our reports to Government is largely determined by the availability of data from ASHE, which, like its long-running predecessor the New Earnings Survey, is collected by the Office for National Statistics (ONS) in April each year. Although the ONS has been able to push forward publication of the data to October to assist the Commission, we are unable to obtain the data any earlier and this means there is little scope to change our timetable for reporting to Government.

7.76 If minimum wage upratings were implemented in April each year, this would address one of the BRC's concerns, since the full impact of the most recent upratings should be captured in the April ASHE data. However, the notice period would be significantly reduced, perhaps to as little as one month, and employer organisations have indicated previously that a notice period of less than six months would be difficult to manage. October was originally selected as the best time of year for implementing changes to the minimum wage as it was a relatively quiet period for pay settlements (reducing the impact of upratings on pay increases throughout the economy). Furthermore, firms and individuals are now aware that minimum wage upratings take effect from October and many firms have adjusted their pay settlement dates to take account of the minimum wage.

7.77 A further option which the Commission considered as a means to give employers more certainty was a rolling two-year review programme. This would mean that we would submit reports to the Government each February, reviewing our recommendations for the coming October (which were first made a year earlier) in the light of more recent economic data, and making recommendations for October of the following year. In practice this would mean that we would undertake annual reviews, an option we rejected in Volume Two of our third report (2001) for a number of reasons, including the burden this would place on those responding to our consultations. We were concerned that an annual process would not allow adequate time to carry out a comprehensive review or to properly consider how the minimum wage operates in practice.

7.78 While we recognise that there are some disadvantages associated with the timing of our reviews and the effective date for minimum wage upratings, the other options which we considered present difficulties as well. We have found no ideal solution which would address all the points raised by the different interest groups. Given that the present system is increasingly familiar to those affected by the minimum wage, and that we believe it is working reasonably well, we do not propose any changes. Nevertheless, we will keep the issue under review.

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Conclusion

7.79 At the time of the fourth report (2003) we stated a medium-term objective (para 6.39):

'We believe that there is a case for increasing the effective level of the minimum wage, implying a series of increases for a number of years above average earnings, and increasing gradually the number of people benefiting. We are also however, conscious of the need for caution in economic conditions which could prove difficult. We have therefore decided not to recommend the full adjustment to a new level in two years, but to take a partial step towards that end....'

Since we set out that objective, economic conditions have improved. Economic growth has turned out to be stronger than the consensus expected, while inflation has been well contained within the Bank of England's target. Employment has continued to be robust, and our research has not identified any significant adverse consequences resulting from the minimum wage. The effect of the October 2004 uprating has not yet been fully captured in the published data. Even so, the overall economic situation remains sufficiently robust that we feel confident in recommending a further uprating of the minimum wage that, taken over the next two years, achieves a modest uprating relative to average earnings.

7.80 But we have also noted some concerns. Many employers and their representative organisations have expressed serious misgivings about the recent pace of minimum wage increases. The last two increases, amounting to 15.5 per cent over two years, have caused problems with existing reward structures in large companies as well as small. The 7.8 per cent uprating of the adult minimum hourly rate in October 2004 came too late to be fully reflected in the data we were able to analyse.

7.81 Our recommendations strike a balance between these different considerations and concerns. They continue the increase in the level of the minimum wage relative to average earnings which we proposed in our fourth report (2003) but at a gradual pace and with a smaller increase in the first year to allow business the chance to absorb fully the impact of the 2004 upratings.