Chapter 1: Introduction

The Government set the terms of reference for this report in August 2004. We were asked to monitor the impact and review the levels of the minimum wage and to make any consequent recommendations for change. Subsequently, in October, the Government enlarged the remit, asking us to consider a number of other issues including the incidence of the youth Development Rate and the likely cost to employers of the intention to ensure that bank holidays were not treated as counting towards workers' statutory leave entitlement. We were asked to report by the end of February 2005.

As with previous reports, we have based our recommendations on evidence gathered from a number of sources and by a variety of means. We commissioned thirteen research projects and we carried out a survey of mainly small firms in low-paying sectors. We analysed relevant data provided by the Office for National Statistics. We consulted workers and their representatives and we consulted employers and their representative bodies. We visited different parts of the UK to listen face-to-face to some of the employers and workers most affected by the minimum wage. Finally, in the Autumn of 2004 we undertook a formal process of consultation taking written and oral evidence from a wide range of organisations.

Chapter 2: The Impact of the National Minimum Wage

The October 2003 and October 2004 upratings combined increased the minimum wage by 15.5 per cent compared with an increase in average earnings of just under 8 per cent between October 2002 and October 2004. Before that two year period, the minimum wage had increased since its introduction at a rate roughly equal to average earnings. We now estimate that workers in at least 1.1 million jobs benefited from the 2004 upratings. These are workers whose pay increased between April and October 2004 from below the October 2004 rate to equal or exceed it. We estimate the impact on the aggregate wage bill of pay increases for these beneficiaries to be 0.08 per cent. In addition, many other workers may have benefited from the October 2004 upratings prior to April 2004, when the earnings survey on which we base our estimates was conducted. Many formal pay settlements are implemented in January and early April and any wage increases made then in anticipation of the October increase would not show up in our estimates of beneficiaries.

Low pay continues to be concentrated among certain sectors and groups of workers. The main beneficiaries of the increase in the National Minimum Wage are women, part-time workers, some minority ethnic groups, young people and those who have a work-limiting health problem.

Since our fourth report the UK economy has grown faster than its long-run trend. The labour market continues to be remarkably robust. Employment is at record levels and unemployment is at its lowest for thirty years. Wage and price inflation pressures continue to be relatively subdued.

Overall, employment has increased among the groups of workers and in the sectors most affected by the National Minimum Wage. The main exceptions to this have been agriculture and the textiles, clothing and footwear sectors (the decline is a long-term trend attributable mainly to external factors) and young workers. The low-paying sectors are considered in Chapter 3; young workers are covered in Chapter 5. Among young workers, for those aged 18-21 the fall in employment has eased, remaining largely unchanged since the Autumn of 2003. Employment rates for 16-17 year olds continue to fall. But commissioned independent research found minimal negative impact of the minimum wage on employment.

In written and oral evidence, many employers told us that they were finding it a struggle to accommodate the two consecutive large increases in 2003 and 2004. Our data suggest that there has been only a small impact on the wage bill, but there is evidence suggesting that differentials have been squeezed.

There is little evidence that the minimum wage has had any impact on profits at the macroeconomic level. We did, however, find some evidence of small negative impacts on profits at the individual firm level, but not on a scale that led firms to close down or to lay off workers. We found no significant effects of the minimum wage on either prices or overall productivity, although we found some evidence of small positive effects on labour productivity in the service sector.

We again note the importance of accurate and reliable data on low pay to inform our assessment of the impact of the minimum wage. We therefore welcome the improvements made so far and we would encourage the Office for National Statistics to continue to review and improve the quality of these data.

Public sector workers are generally paid above the National Minimum Wage. The impact on public sector wage bills of the 2003 and 2004 minimum wage upratings has therefore been minimal. The 'Agenda for Change' in the National Health Service will further improve the wages of the public sector workforce.

Chapter 3: The Effects of the National Minimum Wage on Specific Sectors and on Small Firms

We have identified nine sectors of the economy where low pay is common and which are most affected by the minimum wage. These nine sectors provide around six million employee jobs, nearly a quarter of all the jobs in the UK economy. About three-quarters of these jobs are to be found in the retail and hospitality sectors.

We found evidence of continued employment growth in the two largest low-paying sectors and stable or growing employment in most of the others. In the two sectors where job numbers are falling, i.e. the agriculture sector and the textiles, clothing and footwear sector, the decline is part of a long-term trend attributable to external factors. As in previous reports, we found that the cleaning and security industries experience some problems in renegotiating long-term contracts to take account of minimum wage upratings.

The evidence presented to us has suggested that the minimum wage is becoming less of an issue for some small firms, but, conversely, a more significant issue for some large firms. There is, for example, evidence that some larger firms - particularly in the retail sector - are, for the first time, having to make adjustments to their pay structures as a result of recent increases in the National Minimum Wage. Overall we have found no evidence of any insuperable difficulty in coping with the October 2003 upratings, nor have we discovered any negative impact on employment. But our analysis concentrates on the impact of the October 2003 upratings, with only limited data available relating to the October 2004 upratings. We are aware that many employers in the low-paying sectors have expressed concern about the impact of the increase in the adult rate to £4.85 per hour.

We also discuss in this Chapter the complex issue of salary sacrifice, an arrangement whereby a worker agrees to a reduction in pay in return for a non-cash benefit, and note that the National Minimum Wage Regulations do not permit those earning the minimum wage to participate in these schemes. We conclude by recommending that the Government invite us to consider the issue in depth and to report back by February 2006.

We recommend that the maximum daily accommodation offset should increase to £3.90 in October 2005 and £4.15 in October 2006, in line with our recommendations for the adult rate of the minimum wage.

We continue to receive evidence that some local authorities are not taking full account of minimum wage upratings, including the costs of travelling time, when calculating fees for private care provision. We note that progress has been made in this area and recommend that the Government continue to make clear to local authorities that policies on commissioning care should reflect the costs of provision. We also recommend that the Government should monitor the approach of local authorities to the funding of social care. Two further issues which affect the social care sector are 'sleepovers' and on-call arrangements. We believe that greater publicity of the guidance is needed to ensure that the rules are understood.

Chapter 4: Groups of Workers and Specific Enforcement Issues

Women, ethnic minority and disabled workers are disproportionately represented among the beneficiaries of the minimum wage. Two-thirds of the beneficiaries of the 2004 upratings are estimated to be women workers.

We found clear evidence suggesting that the minimum wage has had a major impact in narrowing the gap between the pay of women workers and that of men at the lower end of the earnings distribution. Although still significant, the gender pay gap has also been narrowing slowly for some time in the middle range of the pay distribution independently of any influence of the minimum wage. The minimum wage has now had such a marked effect at the bottom of the distribution that only a very large uprating in relation to average earnings would have much further effect.

Upratings of the minimum wage have also helped to raise the wages of disadvantaged workers, particularly those with work-limiting disabilities, without harming their employment opportunities. In common with the rest of the labour market, the employment situtation of disadvantaged groups has improved in recent years. Indeed, in many respects, those groups whose position in the labour market was weakest have demonstrated the greatest gains in employment.

The pattern of pay by ethnic group is complex. Although some minority ethnic groups suffer a pay penalty compared with the white majority, others do not. Indeed, some men from minority ethnic groups tend to earn more than their white counterparts and black women earn more on average than white women. However, some minority ethnic groups (such as those originating from Bangladesh and Pakistan) continue to earn considerably less than the average. The minimum wage has improved the position of these disadvantaged ethnic groups without adverse employment effects. Indeed employment rates of disadvantaged ethnic groups, though lower than those of white workers, are increasing.

The analysis in this Chapter also reveals the poor position of part-time workers relative to full-time workers. Part-time work is more commonly available in low-paying occupations. While female full-time workers have made significant progress in closing the earnings gap with male full-time workers, the same is not as true of female part-time workers. However, there is no gap between the earnings of female part-time workers and male part-time workers over most of the distribution. This suggests that while the labour market for full-time workers has strengthened, the pay and conditions of both male and female part-time workers has trailed behind.

Homeworkers are a largely hidden workforce. It is estimated that there may be up to one million of them, of whom 90 per cent are probably women, many of them from minority ethnic groups. These workers face particular difficulties in enforcing their rights to the minimum wage. We believe that the new system of fair piece rates, which replaced the fair estimate agreement system, will help improve the situation of homeworkers. However, we continue to believe that this is an important area for enforcement activity. We would welcome any steps taken by the Government to heighten awareness of the minimum wage among these vulnerable workers.

We continue to believe that people with disabilities should be entitled to the minimum wage and recognise that the Government's revised guidance since the publication of our fourth report (2003) has helped resolve many of the uncertainties about entitlement to the minimum wage. But we wish to highlight the fact that minimum wage upratings can result in some disabled people reducing the number of hours they spend in paid employment to avoid breaching the £20.00 per week earnings disregard. We would encourage the Government to take this into account as part of its efforts to increase work incentives for those with disabilities.

Some voluntary sector organisations have pointed to a lack of clarity about the position of volunteers. We recommend that the Government should review and draw together existing guidance into a single source to provide clear and accessible advice to the voluntary sector.

Chapter 5: Young People and Trainees

The number of jobs held by 18-21 year olds that benefited from the October 2004 uprating of the youth Development Rate is estimated at 120,000; this compares with 70,000 benefiting from the October 2003 uprating. In addition, many young people received pay rises as a result of increases in the adult rate. All the available evidence indicates that the minimum wage has not harmed the employment prospects of young people. Employment rates for 18-21 year olds have remained largely unchanged following the October 2003 increases in the minimum wage, though they are below the peaks reached in 2000/01. Total employment levels of young people are increasing, including in low-paying sectors.

The introduction of the 16-17 year old rate in October 2004 benefited up to 45,000 jobs. We will consider the impact of the minimum wage for 16-17 year olds in future reports.

In line with previous experience following a large uprating, the number of young people's jobs being paid below the adult rate of the minimum wage has increased, with a number of firms introducing age-related pay to offset the cost of minimum wage upratings. But other firms are moving in the opposite direction and there is no clear long-term trend. Age-related pay is not widespread and, even in the minority of firms that employ it, its use is often restricted to certain positions or new recruits in the first few months of employment. Where firms have introduced age-related pay, there is evidence that the minimum wage has resulted in age 22 being established as the threshold for payment of full adult rates of pay, whereas previously lower ages tended to be used.

The forthcoming implementation of the Equal Treatment Directive outlawing age discrimination at work increases the need to ensure an appropriate youth Development Rate. We are strongly convinced that there is a need for a youth Development Rate which is lower than the adult rate and that adverse consequences for some young people would result if employers were not able to pay some younger workers below the adult minimum wage level. But we believe that the most appropriate cut-off point between the youth Development Rate and the adult rate is at the 21^st birthday. We therefore again recommend that 21 year olds should receive the adult rate of the National Minimum Wage.

The exemptions from the minimum wage for apprentices continue to work well, while the older workers' Development Rate remains little used. We believe that implementation of the Equal Treatment Directive will necessitate a change to the present requirement that apprentices must be under the age of 26 for the 12 months exemption from the minimum wage to apply. Our provisional conclusion is that the older workers' Development Rate should be abolished from October 2006, and that, simultaneously, the 12 months exemption from the minimum wage should be extended to cover all apprentices aged 19 and over. We recommend that the Government invite the Commission to review these provisional conclusions and make firm recommendations on these matters by February 2006.

Chapter 6: Compliance and Enforcement

Effective enforcement of the National Minimum Wage is crucial to its success. As recognised in our previous reports, the vast majority of employers support and comply with the minimum wage. But we continue to be concerned that a minority of workers are still being underpaid. The Inland Revenue has continued to develop and focus its minimum wage enforcement activities in the light of its experience since the introduction of the minimum wage in 1999. Since our fourth report (2003) the Department of Trade and Industry has taken action to address some legislative anomalies that have arisen and which impeded effective enforcement. We welcome the work that has been done by both Departments, but we believe that more could be done to tackle persistent non-compliant employers and to encourage more workers to report underpayment so that they can receive the pay due to them.

Reviewing the evidence, we are concerned that awareness of the minimum wage remains low in some groups of vulnerable workers. To tackle this, we recommend that the Government review its minimum wage publicity strategy to consider how best to target low-paid workers, with particular emphasis on vulnerable groups of workers.

We also now believe that a more significant deterrent to non-compliance by employers is needed. We therefore recommend that the Government should introduce interest charges payable on arrears arising from minimum wage underpayment and financial penalties for seriously non-compliant employers.

Chapter 7: Setting the Rates

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 22^nd to the 21^st 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.