Setting the Rates

The minimum wage is a successful policy that commands widespread support. Evidence at the macro-economic level continues to suggest that it has benefited many low-paid workers without any significant negative impact on the economy. However, the overall evidence drawn from the past two years paints a more complicated picture. Although the UK economy did less well than we anticipated when we made recommendations in February 2005, it is expected to grow at or above trend during 2007. Company profitability looks healthy but price inflation has grown more strongly than anticipated. Average wage growth has been subdued throughout 2006, but there are signs that wage pressures may be growing.

Labour market data also provide mixed messages. Over the past year there have been increases in the number of people in employment but, simultaneously, the number of people out of work has also increased. For the first time since the introduction of the minimum wage, there has been a fall in the number of jobs in the low-paying sectors.

The Government asked us to take into account, as part of this review of the minimum wage, the planned rise in the statutory annual leave entitlement and we have done so as part of our consideration of relevant economic factors. Our analysis suggests that the majority of employers will be unaffected and that the overall impact on the economy as a whole will be small. However, for some employers the impact of the forthcoming increase in holiday entitlement could be significant and a disproportionate number of those affected are likely to be in low-paying sectors.

Throughout our consultation for this report most employers and their representative organisations voiced support for the minimum wage in principle, but many said they had growing reservations about the scale of recent increases. Conversely, trade unions and some others considered that the minimum wage could and should be increased significantly above the projected increase in average earnings. They believed that this could be done without putting jobs at risk or harming the economy as a whole.

Nearly all of those consulted accepted that the minimum wage should be uprated this year, but there was no agreement as to the appropriate amount. The CBI said that, while the minimum wage should not be allowed to wither on the vine, it was time to call a halt to increases above the growth in average earnings and suggested that an increase in line with prices would be appropriate. The TUC, on the other hand, did not think the minimum wage had reached its optimum level and called for an increase above the projected rise in average earnings.

Weighing the evidence, we came to the conclusion that the present situation requires a more cautious approach than in recent years. The bite of the minimum wage has increased. Using an alternative methodology developed over the past year our calculations suggest that coverage may be significantly higher than previously estimated. There is growing evidence of an impact on pay differentials, particularly in the retail and hospitality sectors. The impact of the substantial 2006 uprating has yet to be fully appraised. The forthcoming increase in annual leave entitlement will add to the costs of some employers in low-paying sectors. There are concerns about price inflation feeding into wage inflation. And, for the first time since the introduction of the minimum wage, there has been a fall in employment in the low-paying sectors. Taken together, we believe that these factors make the case for caution this year.

We therefore recommend that the adult rate of the minimum wage should be increased to £5.52 in October 2007. This is less than the predicted increase in average earnings, but more than the predicted increase in prices and is broadly in line with current pay settlements. We recommend that the Youth Development Rate should increase from £4.45 to £4.60 and that the 16­17 year old rate should increase from £3.30 to £3.40 in October 2007.

We believe that, as the bite of the minimum wage increases, it becomes more important to take decisions based on the most up to date data available. That is why in this report we are making recommendations for minimum wage rates for October 2007 alone. We recommend that the Government invite us to make recommendations for October 2008 in early 2008. Our present view, drawing on the analysis we have made for this report, is that the increases we are likely to recommend for 2008 will be around the predicted rise in average earnings, but much will depend on what happens between then and now in the economy and the labour market. Two of the most important factors will be the movement in average earnings and the level of employment ­ especially employment in the most affected sectors. We will also want to take account of price inflation and whether it falls back in 2007 as predicted.

After four years of substantial increases, this year we have proposed a relatively modest increase, although one in line with the majority of recent pay settlements. However, this year's recommendation needs to be seen in the context of the sequence of recommendations we have made over the last eight years.

Introduction

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7.1 The main factors we considered when we met in January 2007 to agree our recommendations were: the impact of the minimum wage so far (set out in detail in Chapters 2 to 5); the prospects for the UK labour market and the economy in 2007 and beyond; the impact of other Government legislation; and the evidence and views of interested parties gathered over the past two years. This chapter gives an overview of these factors before setting out our recommendations for minimum wage rates for adults, young people and 16­17 year olds for October 2007. For reasons we explain, we do not make explicit recommendations for 2008, but offer instead a broad indication of the likely level of upratings in October 2008. We conclude the chapter by giving our assessment of the likely impact of the recommended rates.

The Impact of the Minimum Wage So Far

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7.2 In terms of the overall position regarding employment, the economic landscape is not as robust as in previous years since the introduction of the minimum wage. Although overall employment levels continued to rise during 2006, the increase in participation among older workers along with the arrival of large numbers of migrant workers from Eastern Europe have reduced the working age employment rate. Unemployment levels and rates have increased. Further, although the number of employee jobs in the economy as a whole has increased, for the first time since the introduction of the minimum wage data from the Office for National Statistics (ONS) show a small decline in the overall number of employee jobs in the low-paying sectors. This has been particularly noticeable in the hospitality sector, one of the largest low-paying sectors.

7.3 Research commissioned for this report (Experian, 2007) found a small but statistically significant negative impact on growth in employment shares for hospitality at a regional level from the large upratings of the minimum wage in 2001, 2003 and, albeit based on provisional data, 2004. The research, in line with earlier research by Stewart (2003, 2004b), found no significant impact from the introduction of the minimum wage. However, small adverse regional effects on employment have been found by Riley and Young (2001) and Galindo-Rueda and Pereira (2004). In general, our research programme has to date found no significant impact at the individual worker or whole economy level. The data are not yet available to investigate fully the impact of the most recent rises in the minimum wage but, so far, we are aware of no evidence demonstrating that the minimum wage has had a significant adverse effect on employment since its introduction.

7.4 Before this report we had no evidence of adverse effects on inflation but research commissioned for this report from Wadsworth (2007) suggests that the costs of the minimum wage increases may have been passed on in higher prices for some products and services that are associated with minimum wage employment. However, he found that, at the aggregate level, the minimum wage does not appear to have significantly impacted on economy-wide prices.

7.5 The overall level of profitability in the economy does not appear to have been affected significantly by the minimum wage, but it is not possible from the data available to rule out any effect. Experian (2007), while noting data limitations, found no significant impact of the minimum wage on profits in retail or hospitality. However, previously commissioned research (Draca, Machin and Van Reenen, 2005) found an impact on the level of profitability of firms that predominantly employed workers paid at or around the minimum wage, but the evidence suggested that the impact had been modest.

7.6 In reviewing our estimates of the number of workers covered by the minimum wage, we developed an alternative way of calculating the overall number affected. By 'downrating' the current minimum wage back to 1998, we can compare its value and coverage with the introductory level of the minimum wage using the 1998 earnings distribution. The advantage of this method is that the 1998 earnings distribution predates the introduction of the National Minimum Wage in April 1999 and so should be essentially unaffected by the legislation. The October 2006 adult minimum wage was worth about £3.95 in 1999 terms (35 pence more than the introductory level of £3.60). Using this method, coverage increases from about 0.86 million (4 per cent of all adult jobs) when the minimum wage was introduced to about 1.65 million (7.7 per cent of all adult jobs) in October 2006.

7.7 This suggests that we were right to be more cautious in our 2005 Report than we had been in our Third Report (2001a) and Fourth Report (2003). In the 2005 Report we recommended that the level of the minimum wage should increase slightly above average earnings growth over the coming two years (2005 and 2006). However, the growth in average earnings turned out to be lower than had been predicted by the Treasury's Panel of Independent Forecasts. As a result, more workers were covered than we had originally envisaged. To date it appears that this wider coverage has been achieved with little adverse economic consequence. However, the full impact of the 5.9 per cent increase in October 2006 cannot yet be determined. We will continue to monitor economic outcomes to identify any minimum wage effects.

7.8 As discussed in greater detail in Chapter 5, young people have fared less well in the labour market than other age groups. While employment for other groups remained robust, participation in the labour market by all workers under the age of 25 has fallen, most noticeably among the youngest ­ those aged 16 to 18. 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. Few jobs held by 16­17 year olds pay below the Youth Development Rate and even fewer jobs held by 18­21 year olds are paid below the adult minimum wage. However, in the light of their relatively weak position in the labour market there remain grounds for continued caution on minimum wage rates for young workers.

7.9 Overall therefore, a review of the evidence available in January 2007 offers firm support for the view that the adult rate has had no significant undesirable macroeconomic consequences. On the other hand, there is some evidence to suggest that the large number of migrant workers, combined with increased participation among older workers and those previously claiming sickness benefits, has put downward pressure on wages, especially at the lower end of the skills range. As a consequence, wage growth has been lower than might have been expected given the strength of the labour market. There are concerns that recent rises in price inflation may feed into pay settlements, which in turn would lead to an increase in prices. Moreover, after rising in line with the growth of whole economy employment, employment in the low-paying sectors has at best been static since the fourth quarter of 2005 and throughout 2006. These factors suggest that a period of caution is advisable. At the same time, our recommendations also need to reflect the prospects for the economy in 2007 and 2008. In the next section we consider recent economic forecasts and trends in prices, earnings, and pay settlements.

The Economy

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7.10 In recommending the minimum wage rate, we need to review the economic outlook in order to gauge the ability of firms to absorb increased wages without detrimental effects on employment prospects or inflation. We also use forecasts of price inflation and earnings growth to estimate the likely coverage of future minimum wage rates. The next section therefore examines aggregate forecasts before turning to consider how prices, earnings, and pay settlement trends should influence our decisions.

Forecasts

7.11 The UK economy has generally not performed as well as had been anticipated in the 2005 Report when we made our recommendations for the October 2005 and October 2006 upratings. Output growth in 2005 was weaker than expected although it has picked up in 2006, growing slightly faster than expected. Price inflation has grown more strongly in 2005 and 2006 than had been anticipated. Indeed, the latest measures of inflation (for December 2006) are the highest for more than a decade. However, average wage growth has been comparatively subdued although there are signs in early 2007, as we write this report, that wage pressures may be growing.

Table 7.1

Actual Out-turn and Independent Forecasts of Inflation, Unemployment, Employment and Gross Domestic Product Growth (UK) and Average Earnings Growth (GB), 2006­2008

Source: ONS and HM Treasury (January 2007 (forecast for 2007) and February 2007 (forecast for 2008)).

Notes:
1. ONS codes in square parentheses.
2. For employment growth and GDP growth the figures relate to 2006 Q3.

7.12 Looking forward, the consensus of forecasts (January 2007) for the UK economy suggests that Gross Domestic Product (GDP) growth will continue to grow at around trend, albeit slightly weaker than in 2006 (see Table 7.1). At the same time, inflation as measured by the Consumer Price Index (CPI) is predicted to fall from 2.7 per cent in the fourth quarter of 2006 to the Bank of England's target of 2.0 per cent by the end of 2007. The Retail Price Index (RPI) is also forecast to fall from its 14 year high in the fourth quarter of 2006 of 4.0 per cent to below 3.0 per cent before the end of 2007. Average earnings growth is forecast to be about 4.3 per cent in 2007, a slight pick-up on the 4.0 per cent recorded in the fourth quarter of 2006.

7.13 Clearly there are many factors that could lead actual outcomes to differ from these forecasts. These include the level of migration; the incentives for older workers and those previously on disability benefits to participate in the labour market; the level of inflation and interest rates and the strength of the housing market and the consequent impact on consumer spending; and the appreciation of sterling and the strength of the world economy, particularly the softening in the United States, the continued strength in Asia and the strength of the recovery in the Eurozone.

Changes in Pay and Prices

7.14 As shown in Chapter 2, since its introduction in April 1999 the minimum wage has more than kept up with the increase in average earnings and has thus risen faster than prices. If the adult minimum wage had been increased in line with the RPI price index since its introduction, its value would have been £4.36 in October 2006, significantly below the actual adult minimum wage level of £5.35. Alternatively, if the adult minimum wage had increased in line with average earnings, its value in October 2006 would have been £4.87. This outcome reflects the fact that since October 2001 the growth in the minimum wage has outpaced increases in average earnings.

7.15 Uprating the initial level of the Youth Development Rate (£3.00) by average earnings would have led to a rate of £4.06 by October 2006, showing that at its current level of £4.45 the Youth Development Rate has also increased faster than average earnings growth.

7.16 Pay settlements data also provide important information on earnings. Incomes Data Services (IDS, 2007), Industrial Relations Services (IRS, 2007), Labour Research Department (LRD, 2007) and the EEF (2007) have all found median pay awards throughout 2006 to have been consistently around 3.0 per cent. Although pay settlements are currently stable, IDS has reported that there have been recent upward pressures on the upper and lower quartiles of pay settlements, but this has yet to feed into the median. Further, LRD (2007) finds that recent increases in prices have fed into settlements, increasing the median to 3.2 per cent. However, IRS reports that employers believe that settlements will remain around 3 per cent in 2007. All these measures remain consistently below the growth in average earnings. This is because negotiated settlements generally exclude merit awards, promotion, and other pay drift effects.

¹ Four out of 236 worked days (52 weeks x 5 days = 260: subtracting 24 annual leave days gives 236 working days). The Department of Trade and Industry (DTI) uses 260 days as the base for its calculations, and hence calculates the direct impact on wage bills to be 1.5 per cent.

7.17 The continued subdued nature of growth in average earnings and pay settlement data suggest that the labour market is not overheating and that skills shortages are being met, as increased participation by older workers and continued high levels of net migration exert downward pressures on wage demands.

7.18 If the minimum wage were to be increased between October 2006 and October 2007 at the same pace as pay settlements agreed in 2006, the adult minimum wage would rise to £5.51 per hour in October 2007. Projecting the current Youth Development Rate and the 16­17 year old rate forward on the same basis would give rise to rates of £4.58 and £3.40 respectively in October 2007.

Annual Leave Entitlement Changes

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7.19 In our remit, the Government asked us to take account of forthcoming changes to legislation affecting the statutory annual leave entitlement. At present, the regulations do not require bank holidays to be regarded as additional to the statutory entitlement to four weeks paid annual leave and some employers have counted them as forming part of the entitlement (or its pro rata part-time equivalent).

7.20 The Government intends to increase the statutory annual leave entitlement in Great Britain from 4 weeks to 4.8 weeks in October 2007 and 5.6 weeks in October 2008 (similar legislation is to be introduced simultaneously in Northern Ireland). The new entitlement will cover all workers and be applied pro rata for part-time workers. Workers will be able to carry forward some of their additional entitlement (with their employer's agreement). The Government has ruled out allowing employers to 'buy' ­ or workers to 'sell' ­ the additional days of annual leave.

7.21 If no worker were currently entitled to more than 20 days paid leave, the new proposals would mean that all employers would have to allow for an additional four days annual leave from October 2007 (pro rata for part-timers) for which all workers would need to be paid. Assuming that employees work a five-day week, this would be equivalent to roughly a 1.7 per cent increase in their annual earnings¹. Thus the maximum increase to the total direct wage bill would be around 1.7 per cent. However, the real impact of these proposals will be much lower as most employees already enjoy paid leave on bank holidays in addition to their basic entitlement of 20 days.

7.22 In its Regulatory Impact Assessment (DTI, 2007d), the Government estimated that up to 19 per cent of workers would be affected by the increase in annual leave entitlement to 5.6 weeks. It further noted that hospitality would be the most affected industry with up to a half of all workers affected. For all sectors, it found that the numbers affected by the increase from 4.8 weeks to 5.6 weeks was slightly more than the numbers affected by the initial increase from 4 to 4.8 weeks.

7.23 The Government estimated the direct cost to employers of the proposed October 2007 changes (from 20 to 24 days annual leave) to be around 0.2­0.3 per cent of the total wage bill for the whole economy. The most affected sector, hospitality, would face an increase in the total wage bill of around 0.5­0.8 per cent. The cost of the increase in October 2008 (the full 28 days annual leave entitlement) would be of a similar magnitude albeit slightly higher.

7.24 Using the Labour Force Survey (LFS), and the DTI Paid Annual Leave Survey, our best estimate is that around a third of all workers in the low-paying sectors will be affected by the proposed changes in October 2007. Further, we estimate that in the whole economy, at most 40 per cent of low-paid employees will be affected. In terms of direct costs, this is about 0.5 per cent of the wage bill for the low-paying sectors and 0.7 per cent for all low-paid employees. We found that hospitality was likely to be the most affected sector, with direct wage bill costs of around 0.7 per cent for the initial increase to 4.8 weeks. Our estimates are slightly higher than the industry estimates of 0.9 per cent for the entire 5.6 weeks submitted to us by the British Hospitality Association (BHA) in its written evidence. However, our estimates do not take account of indirect costs or any benefits such as reduced staff turnover or improved staff morale. They also assume full compliance, while the relevant LFS data suggest that the level of compliance with the existing legislation is far from complete.

7.25 To sum up, many workers already enjoy the proposed levels of annual leave and therefore the majority of employers will not be affected by the legislation. However, for some employers the impact will be the full 1.7 per cent in October 2007. We conclude that the impact of the first phase of the increase in annual leave entitlement (an extra 0.8 weeks in October 2007) will be small overall, but could be significant for some employers. The impact of the full additional 1.6 weeks, due to be implemented in October 2008, is estimated at around double the estimates of the first phase.

The Views of Interested Parties

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7.26 The macroeconomic data referred to above suggest that, while there are reasons to be optimistic about the performance of the UK economy in the coming year, there are also reasons to be cautious. Macroeconomic data are an important factor in our deliberations, but we also pay great attention to the evidence we gather from our consultation exercises. As in previous years, our consultation took several forms. We conducted a formal written consultation exercise over the Summer of 2006. We visited many different parts of the United Kingdom to talk to individuals and firms directly affected by the minimum wage. For two days in October 2006 we heard oral evidence from key interest groups. We also held numerous informal meetings with interested parties at their request and we arranged a series of meetings and visits by members of the Low Pay Commission secretariat. A list of organisations that were involved in our consultation and gave consent for us to publish their names can be found at Appendix 1.

7.27 As in previous years, the majority of employer organisations continued to voice support for the minimum wage in principle, but expressed reservations about the way it was developing in practice. This time round the level of concern was arguably more substantial, particularly with regard to the pressure on differentials. Nearly all employers welcomed the statement in the 2006 Report that the Commission would no longer start with a presumption that future increases would be above the predicted rise in average earnings. Many employers argued that the minimum wage should be uprated more cautiously, preferably with reference to price inflation or wage settlements rather than the growth in average earnings.

7.28 Trade unions and some other organisations, on the other hand, argued that further substantial increases in the minimum wage were needed and could be achieved without harm to jobs in the low-paying sectors or the economy as a whole. They called on us to continue to recommend increases to the minimum wage that exceeded the predicted increase in average earnings.

' The TUC calls on the LPC to recommend the highest increases that can be sustained without causing detrimental economic or social effects ... We recommend that the minimum wage should continue to rise at a rate that exceeds the predicted growth in average earnings. '
TUC evidence

' The CBI believes that the NMW has now reached an appropriate level of coverage ... and any further increases above average earnings growth would have a significant detrimental impact on both employers and employees. '
CBI evidence

7.29 The CBI acknowledged that, so far, the National Minimum Wage had given rise to no negative macroeconomic consequences, but reported that many employers believed that further large increases would have a significant detrimental impact. The CBI was concerned that economic growth would be slower in 2007. With business facing rising costs elsewhere and increasing employment regulation, further large rises in the minimum wage would, the CBI argued, impact heavily on firms' employment and pay policies. For 2007, the CBI saw no case for further increasing the scope or coverage of the minimum wage. It argued that there was a strong case for a 'pause year', with only a modest rise in the minimum wage and with prices, not earnings, being the preferred yardstick.

7.30 The TUC, on the other hand, maintained that the economy was predicted to perform well in 2007. The TUC argued that, were we to propose a minimum wage uprating below average earnings growth, it 'would be to begin to undo the good work that the LPC has done so far.' It called for an adult rate of more than £6.00 an hour by October 2008. In the written consultation exercise that closed in September 2006 the unions generally argued that the economy was strong and likely to remain so. The Transport and General Workers' Union (T&G) argued that inflation was stable and employment was at record levels with inactivity falling. The minimum wage, the T&G maintained, had so far had little impact on employment, either at aggregate level or among low-paying sectors. Like the TUC, the Union of Shop, Distributive and Allied Workers (Usdaw) and the T&G supported a wage of £6.00 by October 2008. Others proposed more substantial increases. UNISON, for example, argued that, given the benign economic conditions, the minimum wage should be set at £6.75 by October 2008.

7.31 Employers tended to disagree strongly with such figures. The British Retail Consortium (BRC) reported that the total number of workers employed by large retailers had fallen by three per cent between 2005 and 2006 ­ amounting to a reduction of 61,000 jobs. BRC surveys suggested that both large and small retailers envisaged shedding jobs depending on the level of the minimum wage. The BRC argued that there should be no increase in real terms in the minimum wage for the next two years.

7.32 The British Chambers of Commerce (BCC) pointed out that the Low Pay Commission's research findings that found little or no effect of the minimum wage on jobs were concentrated on earlier upratings and took no account of the large increases of 2004 and 2006. The BCC believed that more recent upratings had had an observable adverse impact on employment, particularly for young people and unskilled workers.

' The BRC welcomes the announcement in last year's Low Pay Commission (LPC) report that, in the future, there will be no assumption that the NMW should increase above average earnings. The BRC strongly believes that there should be no increase in real terms for the next two years, to give retailers a chance to absorb the six per cent increase effective from 1 October this year.... '
BRC evidence

7.33 Employers told us on visits and in written submissions that the minimum wage was causing difficulties with differentials. As the wages of the lowest paid increased and approached the level of those above, they said it was becoming more difficult to persuade people that the rewards of promotion were worth the extra responsibilities. On visits, this view received support from some workers who said that some fellow workers regarded the increase in pay that came with promotion as insufficient incentive. The evidence in national data is less clear, but there are indications that differentials may have been squeezed in the retail and hospitality sectors (see Chapter 3). On the other hand, other commentators have pointed out that there is nothing sacrosanct about existing differentials which may reflect outdated notions about the relative worth of particular jobs.

7.34 The Government's plans to introduce an entitlement to a minimum of 5.6 weeks paid annual leave (28 days) was the subject of particular comment. The TUC argued that minimum wage upratings should not be reduced on account of the parallel introduction of better minimum leave entitlements. It said that the proposed increases to annual leave were modest, applied mainly to part-timers and were spread widely amongst the industrial sectors. It said that the far more significant increases in holiday entitlement brought about by the Working Time Directive had been introduced without any noticeable negative impact.

7.35 Employer representatives claimed that the forthcoming increase to annual leave entitlement would impose significant extra costs on many minimum wage affected businesses. The BHA and other hospitality bodies expected the impact to be significant in their sector and they thought that the burden would fall particularly on small employers. The BHA estimated that costs would stem from meeting the leave entitlement of irregular hours workers; employing additional agency staff; and the cost of employer 'buy-out' of entitlement. The Association of Labour Providers thought that the increases in holiday entitlement would add to the risk that labour providers would be driven into the informal economy. Leonard Cheshire Homes anticipated considerable impact arising from the new entitlement ­ 2,000 domiciliary staff would gain another four days holiday in 2007. The Association of Licensed Multiple Retailers believed that there would be a significant increase in wage bills arising from the new entitlement. It estimated that combining the changes would double the increase in wage costs attributable to the minimum wage alone.

7.36 We also received comments on the youth rates, which are discussed in more detail in Chapter 5. Several unions argued for the adoption of the adult rate for all workers. The TUC argued that the rate for 16­17 year olds should be raised by a series of increases above average earnings until it was close to the adult rate. Usdaw argued that the 16­17 year old rate should be equivalent to around 80 per cent of the adult rate. Most union responses argued that there should be no separate rates for younger workers, just a single rate for the job. The British Youth Council claimed that the youth rates endorsed a system that contravened the spirit if not the letter of the new age discrimination legislation. By contrast, the CBI supported the retention of the Youth Development Rate, as did most other employer organisations that commented upon the matter.

The Recommended Rates

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7.37 We have said in previous reports that our overall aim is a minimum wage that helps as many low-paid workers as possible without doing damage to jobs or fuelling inflation. That remains our aim.

7.38 Reviewing all the information placed before us, we concluded in the end that the evidence called for an approach that was careful and prudent. Initially there were mixed views as to the need for caution and the arguments for a less cautious line were set out in detail by some Commissioners. They argued, for example, that the economic indicators for 2007 and beyond were largely positive, with the UK economy expected to grow at or above trend and UK firms experiencing a general growth in profitability. They pointed out that there was no evidence that the minimum wage had harmed jobs and that employment overall was at record levels while other labour market measures (business start-up and job vacancy rates, for example,) pointed to an improving situation. However, while recognising that these arguments had merit, the Commission concluded that the countervailing arguments in favour of caution were more compelling.

7.39 We found, for example, substantial evidence to support the view that the bite of the minimum wage had grown and was having more impact on an increasing number of firms. Our latest alternative calculations of the coverage of the minimum wage ­ based on looking at the value of the minimum wage in terms of the 1998 hourly earnings distribution (outlined in detail in Chapter 2) ­ suggest that coverage may be significantly higher than we have previously estimated. Many firms in the low-paying sectors told us the minimum wage was beginning to cause them difficulties leading them to review staffing ratios, bonus packages and arrangements for premium rates. An increasing number of large firms were finding their lower rates driven by the minimum wage. There was also growing evidence of an impact on pay differentials in some low-paying sectors, in particular retail and hospitality. These considerations suggested the need for a careful approach.

7.40 Furthermore, as outlined in paragraph 7.7 above, because average earnings growth turned out lower than had been anticipated over the past two years, the coverage of the minimum wage proved higher than we had originally intended. Taking the 2005 and 2006 upratings of the adult minimum wage together, the minimum wage increased by about two and a half percentage points above average earnings ­ higher than the increase we intended when we made our recommendation in February 2005. Although the limited evidence available to date suggests that this increase has been absorbed without negative consequences, the available data do not yet allow a full appraisal of the impact of the increase of October 2006, which at 5.9 per cent was substantial in real terms. We saw this as another reason to be cautious.

7.41 Increases in price inflation in late 2006 may lead to an upsurge of wage inflation. We do not believe that recent increases in the minimum wage have been a driver of inflation and we are conscious that it is the lowest paid workers who often suffer most in periods of high inflation.

7.42 As we noted in our 2006 Report, the forthcoming increase in annual leave entitlement will add to the costs of some employers in low-paying sectors. In our remit the Government asked us to take account of the proposed changes. We have done so in the same way we would take into account any other relevant economic factor that adds to employment costs for some employers. It is clear that the impact of changes to annual leave entitlement will not be evenly spread. We estimate that over two-thirds of employees in the low-paying sectors will not get an increase in their leave entitlement and therefore there will be no impact on their employers (see paragraph 7.25). Those firms that are affected will be a minority, but the impact on them is likely to be fairly significant ­ equivalent to about 1.7 per cent of the wage bill for those employees affected. We did not attempt to use a calculation of the costs of the increase in holiday entitlement to offset them by means of a lower recommended rate. Nor did we consider it appropriate to do so, given that the majority of firms in all sectors would be wholly unaffected. Instead we saw the increase in holiday entitlement as another factor suggesting that it might be appropriate to take a prudent approach this year.

7.43 The data on employment in low-paying sectors also gave us reason to exercise caution. Since the introduction of the National Minimum Wage we have been able, in report after report, to point to job growth in the low-paying sectors. However, this year we have seen the first fall in overall employment in the low-paying sectors since the minimum wage was introduced. And also the first falls in employment in hospitality and retail ­ both of which previously had experienced strong growth. While we are not convinced that these losses are attributable to the increases in minimum wage rates, we believe that it is only sensible to exercise caution in the light of such evidence.

7.44 We therefore recommend that the adult rate of the minimum wage should be increased to £5.52 in October 2007. This is less than the predicted annual increase in average earnings, but more than the predicted increase in prices and is in line with current pay settlements. We see this recommendation as a cautious one that affords employers the pause they have been seeking. However, if the Government implements our recommendation, the adult minimum wage will have increased by 13.8 per cent from October 2005 to October 2007. Over the same period, average wages are expected to increase by 12.2 per cent and prices (RPI) by 9.3 per cent. Over the lifetime of the minimum wage, the adult minimum wage will have increased by 53.3 per cent against an expected 41 per cent increase in average earnings.

7.45 As part of our deliberately cautious approach we have decided that it would be sensible to make explicit recommendations concerning the rates for October 2007 alone.

We therefore recommend that the Government ask us to report in early 2008 on recommended rates for October 2008. Our view, drawing on the analysis we have made for this report, is that the increases we are likely to recommend for 2008 will be around the predicted rise in average earnings, but much will depend on what happens between then and now in the economy and the labour market. Two of the most important factors will be average earnings growth and employment ­ especially employment in the most affected sectors. We will also want to take account of price inflation and whether it falls back in 2007 as predicted.

7.46 In line with our cautious approach to the adult rate, we recommend that in October 2007 the Youth Development Rate should increase from £4.45 to £4.60 and the 16­17 rate should increase from £3.30 to £3.40. As detailed in Chapter 5, we are concerned that the employment prospects of younger workers have worsened over the past two years and we did contemplate recommending a lower figure. On balance, however, we felt that a lower increase might prove as much a disincentive to young workers to seek work as an incentive to employers to take on younger workers.

7.47 As discussed in Chapter 5, we continue to be firmly of the view that 21 year olds should be entitled to the adult rate of the minimum wage. The employment patterns of 21 year olds are markedly different from those of 18­20 year olds. The employment rate of 21 year olds is rising and their unemployment rate has levelled off. We think it makes sense to treat 21 year olds as adults and it is clear that most employers agree with us since over 90 per cent of 21 year olds are already paid the adult minimum wage rate or more.

The Impact of Our Recommendations

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Coverage

7.48 The recommended minimum wage rates for October 2007 are below the forecast increase in average earnings. As a result, these upratings are likely to cover fewer workers in October 2007 than in October 2006, when the adult minimum wage rose by 5.9 per cent ­ about 1.8 percentage points more than the increase in average earnings.

7.49 In April 2006, according to ASHE, there were just over 2 million jobs that paid less than the minimum wage rates we are recommending for October 2007. These were made up of around 1.95 million jobs held by those aged 21 and over (8.2 per cent), about 165,000 jobs held by 18­20 year olds (11.9 per cent) and 31,000 jobs held by 16­17 year olds (9.0 per cent).

7.50 However, in order to estimate coverage, we need to make assumptions about how the wages of the low-paid would have increased in the absence of the minimum wage upratings. We assume that wages would have risen either in line with average earnings or in line with prices.

Table 7.2

Estimated Number and Percentage of Jobs Covered by the Recommended October 2007 National Minimum Wage Upratings, UK

Source: LPC estimates based on ONS ASHE with supplementary information, UK, April 2006.

7.51 In past reports, we have highlighted those estimates calculated using the average earnings assumption. However, as demonstrated by Butcher (2005), it seems unlikely that the wages of the lowest paid would have kept pace with average earnings increases. Table 7.2 therefore gives estimates based on both the earnings and the prices assumptions. Assuming that, from October 2007, 21 year olds would be entitled to the adult minimum wage and if the wages of the lowest paid were to increase in line with forecast average earnings, we estimate that at the new rate of £5.52 in 2007, the number of jobs held by those aged 21 and above that would be covered would be about 1.02 million or 4.3 per cent of the labour force. If we assume instead that the wages of the lowest paid would merely have matched forecast price inflation, a greater number of jobs would turn out to be covered ­ between 1.28 million and 1.41 million (5.4 to 6.0 per cent) of the adult workforce depending on the price index used. On this basis we estimate that the new rate for the minimum wage will achieve slightly lower coverage levels than that achieved by the £5.35 uprating in October 2006.

7.52 Given the less certain position of young workers in the labour market, we have also exercised prudence in recommending an increase in the Youth Development Rate in line with the adult minimum wage, of 3.3 per cent in October 2007. If we make the assumption that young people's wages would otherwise rise with average earnings, we estimate that about 101,000 jobs held by young workers (aged 18­20) would be covered by the new Youth Development rate in October 2007 ­ roughly equal to about 7.3 per cent of jobs held by young workers. Using the prices assumption, we estimate that coverage would be between 112,000 and 122,000 jobs (about 8.1 to 8.8 per cent of jobs held by this age group) depending on the price index used.

7.53 Turning to 16­17 year olds, we have again exercised caution. The recommended increase is less than the cautious increases in the other two rates. We estimate using the earnings assumption that 23,000 jobs (or 6.7 per cent of all jobs held by 16­17 year olds) will be covered by the October 2007 uprating. If we assume that the wages of the low-paid would otherwise rise in line with prices, we estimate that up to 27,000 jobs would be covered (around 7.8 per cent of jobs held by 16­17 year olds).

7.54 Overall therefore, we estimate that the total coverage of the recommended October 2007 upratings would be 1.14 million jobs if the wages of the low paid were to increase by the forecast growth in average earnings in 2007, or between 1.4 million and 1.6 million jobs if, instead of increasing in line with average earnings, their pay would otherwise have increased in line with prices.

Coverage by Gender

7.55 We expect that around two-thirds of those covered by the adult minimum wage upratings will be women. In Chapter 2, we estimated that around two-thirds of all minimum wage jobs were held by women. Using the earnings assumption, we estimate that the October 2007 adult minimum wage will cover 665,000 jobs held by women and 354,000 jobs held by men. On our alternative prices assumption, we find that up to 946,000 jobs held by women and 461,000 jobs held by men would be covered by the uprating to £5.52.

Coverage in 1998 Terms

7.56 In Chapter 2, we outlined an alternative method of looking at coverage by looking at the value of the minimum wage in terms of the 1998 hourly earnings distribution. Using this technique, the 2007 October adult minimum wage (£5.52) would have been equivalent to about £3.90 in 1999, when the minimum wage introduced at that time was £3.60. The value of the 2007 October minimum wage would have been about £3.77 in 1998, when the introductory level of the minimum wage (£3.60 in 1999) would have been equivalent to £3.45. The 2007 minimum wage downrated in 1998 terms would have covered about 1.58 million jobs (around 7.4 per cent of all jobs) in 1998. This level of coverage is slightly less than that estimated for the October 2006 upratings but greater than the coverage estimated using more recent data.

Position Relative to Average Earnings

7.57 Another measure used to assess the value of the minimum wage is its relationship to average earnings, otherwise known as its 'bite'. We can measure the 'bite' by comparing the minimum wage with median earnings, our preferred measure, or mean earnings.

7.58 In April 2006, according to ASHE, the median gross hourly earnings (excluding overtime) of all employees (full and part-time) were £9.88 an hour. Uprating that figure by the growth in average earnings (including bonuses), both actual and predicted², yields a basis for comparison with the minimum wage. The figure arrived at in this fashion is £10.51 for October 2007. The new recommended adult rate of the minimum wage will thus be about 52.5 per cent of forecast median earnings, or more than half median earnings. This compares with a 'bite' of about 53.1 per cent in October 2006 and 47.6 per cent when the minimum wage was introduced in April 1999. Using the mean, we estimate that the 'bite' in October 2007 will be about 41.4 per cent for all employees.

7.59 If instead of looking at the median earnings of all workers, we looked just at those of full-time workers and compared the minimum wage with median full-time hourly earnings excluding overtime, the corresponding 'bite' would be nearly 47 per cent in October 2007. Comparing this UK ratio for full-time employees with that of other countries, the UK is roughly on a par with the Netherlands ­ in the middle of the twelve countries used as a basis of comparison in Appendix 4.

² Actual ONS data used for April 2006 to October 2006. 2007 forecasts used for October 2006 to October 2007.

Wage Bills

7.60 As the recommended increase in the minimum wage is below the predicted rise in average earnings and only just above the forecast rise in prices, the impact of our recommendations on the overall wage bill is likely to be small. The impact of the recommended upratings in 2007 would not be even across the economy. As discussed briefly in Chapter 2 and in more detail in Chapter 3, the impact is expected to fall more heavily on small firms and those firms in the low-paying sectors. This will again be the case for the 2007 upratings. Further, the impact of changes to annual leave entitlement is also likely to be greatest for small firms in certain low-paying sectors.

Public Sector

7.61 The minimum wage can affect the public sector in two ways: first, by its direct impact on the public sector wage bill; second, by the impact on the Exchequer of any savings resulting from reduced benefits as the minimum wage increases.

7.62 The estimated effect of the recommended rates on the public sector wage bill is small. There are two reasons for this. First, as we noted in Chapter 2, few public sector workers are affected by the minimum wage. Second, as we noted above, the estimated impact on the private sector (which has a far greater number of affected workers) is expected to be small as the recommended increase this time is in line with current pay settlements and only slightly above price inflation.

7.63 We asked the Government to provide a breakdown of the impact of increasing the minimum wage on various taxes and benefits. Table 7.3 below summarises the impact of hypothetical 10 pence and 30 pence increases in the minimum wage. As can be seen, the main impact is the increase in income tax and National Insurance for minimum wage earners that results from the increase in earnings. The Government also stands to make substantial savings from reductions in Working Tax Credit. For larger increases, reductions in Child Tax Credit are also important.

Table 7.3

Government Savings from Hypothetical Increases in the National Minimum Wage, £ Million, UK, 2007­2008

Source: HM Treasury estimates based on Family Resources Survey data for 2004/05, uprated to 2007/08, UK.

Note: These figures take account of changes in tax credits, benefits, taxes and National Insurance Contributions but do not take any account of likely behavioural change caused by a rise in hourly pay, such as changed levels of employment or hours worked. They also do not include the effect of the £25,000 disregard in tax credits, which allows income to rise between one year and the next by up to £25,000 before tax credits begin to be withdrawn. This means that the reductions in tax credits would in practice be significantly smaller, at least in the initial tax year.

The Impact on Low Incomes

7.64 As part of a wider Government strategy to make work pay, the National Minimum Wage interacts with the tax and benefits system to provide financial incentives to increase participation in the labour force.

7.65 The Pre-Budget Report (HM Treasury, 2006c) provided details of minimum income guarantees for April 2007 as a result of the interaction between the benefits system and the £5.35 per hour adult rate of the minimum wage (a hypothetical increase of the minimum wage to £5.60 is given in parentheses)³. These were:

• £275 (£277) a week for a family with one child and one earner working for 35 hours on the adult rate of the minimum wage. This would be equivalent of £7.86 (£7.91) per hour take home pay once tax credits and benefits are taken into account;

• £178 (£181) 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. This equates to an hourly rate of £5.09 (£5.17).

³ HM Treasury estimates based on Family Resources Survey data for 2004/05, uprated to 2007/08. Also see note to Table 7.3.

The Cycle of Recommendations

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7.66 In previous reports we have noted various concerns, expressed mainly by employers, about the process and the timetable the Commission has followed in producing its recommendations. Some have said they would favour a form of indexation to make future upratings more predictable. Others have called for more notice of upratings. A third view was that the Commission's habit of recommending a rate two years in advance entailed basing a judgement on analysis of data and other information that was up to two years old by the time the rate came to be implemented.

7.67 We have looked at our processes and concluded that there is no single pattern of review cycle that could meet the wishes and needs of all stakeholders. If we opt to give maximum notice, we make recommendations based on older, less current information and data that does not take account of the impact of previous increases in the minimum wage. If we want to use the latest and best data, we have to make recommendations as late as we can, thereby giving little advance notice.

7.68 Reflecting on these matters, we concluded that as the bite of the minimum wage increases it becomes more important to take decisions on the best available data. Therefore, we have decided this year to limit our recommendations concerning minimum wage rates to October 2007, but to give a broad indication of our thinking about the proper level of the minimum wage in October 2008. This way we are able to use the latest and best data to inform our thinking about the rates we recommend for 2007. We also give some indication of the likely range of the recommendation for 2008, aware that next year we will be able to fine-tune our indicative thinking about 2008 with the aid of the most accurate and up to date figures.

Conclusion

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7.69 In our report two years ago we noted the concern of employers and employer organisations about the pace of minimum wage increases. At that time they told us that increases of 15.5 per cent over two years had caused problems with reward structures in large companies as well as small. Since then the minimum wage has risen by a further 10.3 per cent and employer concerns have grown. In any effective social partnership there must be give and take and a willingness to recognise the legitimate concerns of both sides. After four years of substantial increases, this year we have proposed a relatively modest increase of 3.2 per cent ­ albeit one well in line with the majority of recent pay settlements. In large part this is in response to employers' concerns.

7.70 Our consultation this year revealed that, eight years after it was introduced, the National Minimum Wage still commands the support of the vast majority of employers, workers and their representatives. There are many different views about the way in which it should be maintained and developed, but most of the people we spoke to agreed with the CBI's view that the minimum wage should not be allowed to 'wither on the vine'. This year's moderate recommendations need to be seen in the context of the sequence of recommendations we have made over the last eight years.