Chapter 1: Introduction

In our remit for this report the Government asked us to monitor and evaluate the impact of the minimum wage and to consider its effect on different groups of workers. In this introductory chapter we explain how we set about fulfilling that remit and we describe the different parts of our work programme that have contributed to our conclusions and recommendations.

For this report we commissioned 11 research projects and carried out a survey of firms in low-paying sectors. We analysed data produced by the Office for National Statistics to establish better estimates of the incidence of low pay and to give us a greater appreciation of the sectors and the groups of people involved. We also used Office for National Statistics data to analyse the impact of the minimum wage on earnings, employment and other economic variables, and to estimate the likely impact of the Government's decision to increase statutory annual leave entitlement.

Consultation with employers, workers and their representatives continued to be an essential part of our work. We took written and oral evidence from a wide range of organisations and made visits throughout the UK to listen to the views of those affected by the minimum wage.

Chapter 2: The Impact of the National Minimum Wage

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One of the key ways to measure the impact of the minimum wage is by means of its 'bite' ­ defined as the ratio of the adult minimum wage to the median hourly wage. The bite has grown from 47.6 per cent of median earnings when it was introduced in April 1999, to around 53 per cent in October 2006. Prior to the 2005 Report, the adult minimum wage increased by 35 per cent, while average earnings grew by 26 per cent. When we were preparing our 2005 Report, independent forecasts indicated that the minimum wage increases we were proposing for October 2005 and October 2006 would be slighly higher than average earnings growth. In the event, average earnings grew by less than predicted ­ 8 per cent compared with the forecast 9.2 per cent ­ and, as a result, the bite of the minimum wage increased faster than anticipated. There is little evidence that this had any significant negative impact on employment, profits or prices over the period in question, although it is too early to assess fully the impact of the October 2006 upratings. As with average earnings, the forecast growth in the UK economy for 2005 and 2006 was not fully realised. Although predicted to grow at around 2.5 per cent in both 2005 and 2006, the economy slowed sharply in 2005 before it recovered in 2006. At the same time, price inflation grew faster than had been forecast, with the effect that the minimum wage grew less in real terms than had been expected.

In terms of coverage, using the average earnings assumption, we now estimate that the 2005 minimum wage upratings covered about 0.8 million employee jobs and that the larger increase in October 2006 covered around 1.25 million employee jobs. Estimates using the prices assumption are similar. One disadvantage of the way we traditionally calculate coverage is that it cannot allow for employers putting up wages in anticipation of statutory upratings. In a review of our coverage methodology this year, we developed an alternative approach. By downrating the minimum wage back to 1998 using the growth in average wages we can estimate what coverage would have been in 1998 before the earnings distribution had been affected by the minimum wage. Using this method, we calculated that the 2006 adult minimum wage was equivalent to nearly £4.00 in 1999, higher than the actual introductory rate of £3.60. We estimated that such an introductory rate would have covered nearly 8 per cent of adult employee jobs ­ almost double the estimated actual initial coverage of about 4 per cent.

Despite the slowdown in the economy towards the end of 2004 and throughout 2005, the UK labour market continued to create jobs. Total employment rose to a new record high of 29.03 million in the three months to November 2006. In our 2006 Report we noted that, since 2004, the private sector had experienced slower growth in wages and jobs than the public sector. This situation has been reversed in 2006 with both employment and average earnings growing faster in the private sector.

However, not all employment data are positive. Worryingly, employment in the low-paying sectors as a whole fell for the first time since the introduction of the minimum wage. Employment in these sectors has continued to be below its 2005 level throughout the first three quarters of 2006, but the fall has been weaker with each quarter suggesting that there has been some recovery. This recovery is expected to continue as the evidence suggests that consumer expenditure has picked up after the sharp decline in 2005.

The working age employment rate remained high in 2006, but it fell from the peak reached in the first quarter of 2005. This has been attributed to a number of factors, amongst which was the slowdown in the UK economy in 2005 and the increasing participation of older workers. Unemployment increased throughout 2005 and into much of 2006. The increase in the number of migrant workers and the growing number of older workers and women entering the labour marker were also widely seen as contributory factors. Since October 2006 the unemployment count has slowly flattened and started to fall.

Turning to other economic indicators, we see a mixed picture for 2005 and 2006. The evidence on profits is not consistent. The rate of return on capital employed is currently at or close to its record highs. However, these large and increasing returns are confined to the services and oil sectors. Share prices, as measured on the FTSE, have been strong and have grown substantially in the last 18 months. Profits measured by profit share of national income have also increased and looked healthy in 2006. However, excluding the volatile oil and financial sectors, the profits picture does not look so rosy. One other indicator of profit is the margin between input and output prices. In 2005 there were sharp increases in input prices, mainly as a result of increases in fuel, energy and commodity costs, but the corresponding increases in output prices were much lower. In 2006, input prices have fallen sharply, but remain higher than output prices even though output prices have increased.

Price inflation was subdued until the latter half of 2006. Despite the large increases in the price of oil, consumer inflation in the UK remained stable in 2005 and the first half of 2006. However, price inflation in December 2006 was at its highest for over a decade driven by increases in fuel and food. Labour productivity increased in 2005 and 2006, with a marked increase in the two main low-paying sectors, retail and hospitality.

Over the past two years there has been an improvement in the quality and reliability of the earnings and employment data provided to us by the Office for National Statistics, a development that we warmly welcome. The main changes are set out in Appendix 6. Unavoidably, these improvements have caused another problem ­ discontinuity. The data sets that we most use in our analyses ­ the Labour Force Survey and the Annual Survey of Hours and Earnings ­ are subject to significant discontinuities. This makes comparisons over time difficult and we urge the Office for National Statistics to do everything possible in order to produce consistent time series prior to our next report. We look forward to working with the Office for National Statistics in their continuing efforts to improve the quality of the information provided. We would also welcome additional information on the labour market performance of migrant and agency workers.

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

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We have identified ten industrial sectors of the economy in which low pay is common. Together they provide over eight million jobs, nearly a third of all jobs in the economy. The two largest sectors ­ retail and hospitality ­ account for nearly two-thirds of jobs in the low-paying sectors. Of course many of the jobs in these sectors are paid at a level well above the minimum wage.

While the total number of jobs in these low-paying sectors remains substantially higher than when the minimum wage was introduced, in late 2005 and during 2006 the number of jobs in these sectors declined ­ the first such fall in employment since the minimum wage was introduced. This occurred at a time when the level of employment in the economy as a whole has been growing. It is true that some of the low-paying sectors, such as textiles and agriculture, have been contracting in size for some time, but in 2006 employment fell in sectors which had seen some of the most rapid growth in recent years, namely retail and hospitality. It is difficult to determine what role, if any, recent minimum wage upratings have played in this decline and jobs did not reduce in all low-paying sectors.

We have also identified two low-paying occupational sectors (childcare and office work). During the year to the third quarter of 2006, there was a small increase in the number of employees in low-paid jobs in childcare, while in the same period employment in low-paid office work decreased slightly.

Responses to our consultation provided growing evidence that the minimum wage is having an impact on pay and differentials in the low-paying sectors. Although not new, it was one of the strongest messages coming from the organisations we met during our regional visits in 2006. Other sources of information, such as our oral hearings and commissioned research, also provided evidence of an increasing influence of the minimum wage on pay structures. We found this was particularly marked in hospitality, retail, cleaning and childcare, where a growing proportion of jobs were paid at the minimum wage.

Only a small proportion of workers in agriculture are paid at the National Minimum Wage. It does, however, have a knock-on effect on differentials for the agricultural minimum rates set by the Agricultural Wages Boards. In the textiles and clothing sector, employers with incentive based pay systems reported that the minimum wage was having an increasing effect on their arrangements. The impact of the minimum wage on pay in office work occupations and in the security and food processing sectors looks to be more limited, although in the case of the latter sector there is some evidence that it is growing. The overall impact on small firms appears to have been fairly stable between 2004 and 2006.

In the year to September 2006, the social care sector experienced the largest increase in employment of all the low-paying sectors. While overall the sector has a comparatively small proportion of jobs paid at the level of the minimum wage, this proportion is far greater in the independent than the public care sector.

In their evidence some independent sector care providers again stressed the difficulties they faced as a result of local authority funding failing to reflect adequately the increases in the costs of care. Such costs included the cost of minimum wage upratings. We noted this problem in our 2005 Report and recommended that the Government should make clear to local authorities that policies on commissioning care should adequately reflect the costs of provision. We recommended that the Government should monitor the approach of local authorities in this regard and examine the reasons for any uneven provision. We also said that, if appropriate, it should provide further guidance.

We recognise the progress that has been made on the funding of social care, but the evidence suggests that the problem we identified in our 2005 Report persists in some areas of the UK. Moreover, we have seen no evidence of effective monitoring of local authority practice in this regard, as we recommended. We therefore reiterate our 2005 Report recommendation but with greater emphasis on the need for the Government to monitor actively how far the practice matches the policy. It would be helpful for such monitoring information to be made available to us when we next review the sector.

Chapter 4: Groups of Workers and Specific Enforcement Issues

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Our remit asked us to assess the impact of the minimum wage on different groups of workers, including ethnic minorities, women and people with disabilities. These groups of workers are disproportionately represented in low-paying sectors and therefore stand to benefit more than most from upratings of the minimum wage.

In the 2005 Report, we found clear evidence that the minimum wage had had a major impact in narrowing the gap between the pay of women and that of men at the lower end of the earnings distribution. Since then, the median pay gap for full-time female employees has reduced further and the pay gap at the lower end of the distribution has continued to narrow.

In common with the rest of the population, the employment prospects of workers with a work-limiting disability have improved in recent years, but they have recently experienced a slight increase in unemployment.

Minority ethnic groups (as defined by the 2001 census) have also fared better in the labour market in recent years. Although the employment rates of ethnic minorities are still lower than those of white workers, they have increased at a faster rate since the introduction of the minimum wage. There has also been a sharp decline in the unemployment rates of ethnic minority groups between 1999 and 2004. Since 2004, however, the unemployment rates of ethnic minorities have been rising at a slightly faster rate than the rest of the working age population.

The minimum wage has clearly helped to improve the earnings position of workers with disabilities and those from ethnic minorities at the lower end of the earnings distribution.

The arrival of some half a million migrant workers from central and eastern Europe since the enlargement of the European Union in 2004 has been a significant recent development in the UK labour market. Many have found employment in low-paid occupations particularly in the agriculture, food processing and packing, and hospitality sectors. Much of the evidence suggests that these workers have had a positive effect on the overall economy and have filled existing vacancies and plugged skills gaps rather than displacing UK workers. Some migrant workers are vulnerable to exploitation by unscrupulous employers prepared to take advantage of their imperfect knowledge of employment rights. A number of consultation responses suggested that excessive deductions from pay were a particular problem. We discuss the need for effective awareness campaigns and enforcement in relation to migrant workers in Chapter 6.

Following the detailed review of the accommodation offset and resulting recommendations to the Government in our 2006 Report, the Department of Trade and Industry consulted on draft guidance that aimed to clarify the rules and address evasion. The final version is due to be published soon after this report. However, the evidence relating to migrant workers has demonstrated that some enforcement problems remain. We did not focus on the operation of the accommodation offset this year but we did review its level: we recommend that the accommodation offset should increase in line with the adult rate of the minimum wage to £4.30 per day in October 2007.

Homeworkers performing unskilled manual work, often on a piece rate basis, continue to face problems ensuring their employment rights are respected. We received evidence that some employers argue that these workers are self-employed in order to deny their entitlement to the minimum wage. We had hoped that new rules on fair piece rates introduced in October 2004 would simplify the calculation of minimum wage pay but the evidence we received, albeit limited, indicated that there were some practical difficulties associated with applying these rules to output work. In view of the difficulties faced by homeworkers, we continue to believe that this group warrants particular attention in terms of the enforcement of their minimum wage rights.

Despite the publication of guidance on therapeutic activity in 2003, there continue to be reports of suspected non-compliance with the minimum wage. There is no doubt that the minimum wage should apply to all workers regardless of any learning disability or mental health problem, but there are also concerns that inappropriate enforcement action, or the fear of such action, could result in the closure of therapeutic services with no alternative provision available. We welcome the fact that the Department of Trade and Industry has revised and reissued its guidance in January 2007 and we encourage the Government to continue to take steps to improve awareness of the minimum wage among those providing services to people with disabilities or other impairments.

Volunteers are another group whose status can be unclear with respect to the minimum wage. In our 2005 Report we made a recommendation, accepted by the Government, that existing guidance for the voluntary sector be consolidated and made more widely available. Since then, the Department of Trade and Industry and HM Revenue and Customs have worked with a number of sector bodies to clarify the minimum wage position for their respective constituents. In January 2007, the Government announced plans to review the minimum wage in relation to voluntary workers, work which would encompass our earlier recommendation for revised guidance. We stand ready to contribute to such a review and hope the improved guidance that we called for two years ago will be made available in the near future.

We do not want minimum wage rules to cause problems for individuals who are happy to give their time freely to benefit their community. But we received evidence this year indicating that it has become the norm in some parts of the media to expect prospective newcomers to offer their time for little or no financial reward as the price of entry to that industry. The Department of Trade and Industry and HM Revenue and Customs have worked with sector bodies in the television industry on best practice guidance and we hope this will make employers more aware of their minimum wage obligations and reduce non-compliance, whether intentional or not. We will consider how the guidance has affected employer practice in a future report.

Chapter 5: Young People and Trainees

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In our 2006 Report we noted that the labour market for young people had been weakening over a number of years, most noticeably for those not in full-time education. The evidence shows that the sharp increase in the number of inactive 16­17 year olds since 1999 can be largely explained by the increased participation of this age group in full-time education, reinforced by the introduction of the Education Maintenance Allowance in 2004. However, 16­17 year olds not in full-time education have continued to experience a worsening of their labour market prospects since 2005 and at a somewhat faster rate than in the past. We remain particularly concerned about the number of 16­17 year olds (over 120,000 in England alone) who are not in education, employment or training.

Young people aged 18­21 have also continued to fare badly in the labour market when compared with older workers. We are concerned that, since 2001, 18­21 year olds not in full-time education have been experiencing a decline in employment and a rise in inactivity. Since 2004, their unemployment rate has also been increasing. Around 540,000 18­21 year olds not in full-time education were either unemployed or inactive in 2006. Eighteen year olds not in full-time education seem to have been the worst affected. By contrast, 21 year olds have seen their employment rate increase and unemployment rate decrease since 2005.

Conclusive evidence to explain the causes of this decline remains elusive. Evidence from research on the impact of the minimum wage on employers' demand for young people provides a mixed picture, with some firms strongly inclined to employ young employees while others state a preference for older, more experienced staff. While many employers choose to pay young people above the minimum wage applicable for their age, there is evidence of a small increase, since 2004, in the use of age-related pay below the adult rate of the minimum wage.

In the light of the evidence on the labour market prospects of young people, we remain convinced that there continues to be a need for lower National Minimum Wage rates for younger workers as a protective measure. However, we also continue to believe that the 21^st birthday remains the most appropriate cut-off point between the Youth Development Rate and the adult rate. The evidence shows that 21 year olds have fared better in the labour market than 18 and 19 year olds and that the overwhelming majority of them (nine in every ten) are paid at least the adult rate of the minimum wage. We recommend that the Government amend the regulations so that 21 year olds are entitled to the adult rate of the minimum wage.

As recommended in our 2006 Report, the Government abolished the little-used Older Workers' Development Rate with effect from 1 October 2006. At the same time, it removed the upper age limit on the twelve month exemption from the minimum wage for apprentices. A number of consultation respondents commented positively on the recommendation in our 2006 Report that we be invited to review the minimum wage treatment of apprentices and report in 2008. The Government has promised to consider this recommendation, but we still await a definitive response. We remain of the view that it would be appropriate for us to conduct such a review and have reiterated our earlier recommendation.

Chapter 6: Compliance and Enforcement

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The majority of employers support the minimum wage and comply fully with the legislation, but non-compliance remains a problem. The continued success of the minimum wage is therefore in large part dependent upon its effective enforcement. It is important for the majority of law-abiding employers, as well as for those workers who are denied their legal entitlement, that compliance is policed effectively and non-compliance is dealt with rigorously.

Some incidences of minimum wage non-compliance arise through genuine error or misunderstanding. Improving awareness is central to addressing such cases. We recognise that the Government has taken steps to promote greater awareness, but we believe more needs to be done. The situation is perhaps most acute in relation to migrant workers. Despite sharing a common goal, a number of different bodies are currently working independently to raise awareness of employment rights among migrant workers. We believe that a more cohesive approach would help to maximise the impact of the Government's limited minimum wage publicity budget. We therefore recommend that the Government work more collaboratively with other organisations to raise awareness of the minimum wage.

While some employers inadvertently fail to comply, there are others who deliberately set out to evade the minimum wage rules. In all likelihood, such rogue employers will also have scant regard for other employment and tax requirements. Many of these employers will be operating in the informal economy and the workers they employ will be those who are particularly vulnerable to exploitation.

We are encouraged by recent indications of the Government's desire to strengthen the enforcement regime, but we consider that there is still no effective deterrent to non-compliance and no real disincentive for firms contemplating evading the minimum wage requirements. Non-compliance brings the minimum wage into disrepute and on any substantial scale will erode support for it. As we said in our 2005 Report, we do not find it acceptable that employers who underpay the minimum wage are not penalised as long as they pay up when challenged. Conversely, workers who are underpaid receive no more than their arrears of pay and as a result are worse off in real terms. The Government advised us in January 2007 that it was rejecting the recommendation we made in our 2005 Report to redress this imbalance. Although we understand the reasons given for not taking forward the recommendation, we strongly believe that a workable alternative solution needs to be found. We therefore recommend that, as a deterrent to non-compliance, the Government introduce a penalty to apply to any employer found to have underpaid the minimum wage. We also urge the Government to give further consideration to finding a means to compensate workers who have been underpaid. In addition, we believe that employers who flout their minimum wage obligations should be 'named and shamed'.

We support the Government's targeted enforcement programme but continue to believe that HM Revenue and Customs now needs to tackle a more substantial low-paying sector. In our 2006 Report we recommended that a low-paying sector that employed substantial numbers of migrant workers should be targeted, such as agriculture or food processing. In its response, the Government said that it would have been inappropriate to target such a sector, for a number of reasons, one of which was a desire to avoid cutting across the work of the Gangmasters Licensing Authority as it was beginning operations. We understand the Government's position but, in the light of growing evidence that migrant workers are at greater risk of exploitation, we again recommend that the Government choose, as part of its enforcement programme, a low-paying sector with a high concentration of migrant workers to target in 2007/08. To avoid cutting across the work of the Gangmasters Licensing Authority, we suggest a focus on either the hospitality or cleaning sector.

Effective enforcement is important for both workers and good employers. We therefore warmly welcome the Government's commitment to increase the funding for minimum wage enforcement by 50 per cent, as announced in the Chancellor's pre-Budget Report in December 2006 (HM Treasury, 2006c). We believe this provides the scope to make a significant impact on the enforcement of the minimum wage if appropriately directed. The Government has asked us to contribute to its deliberations on how to get best value from these increased resources and we welcome this opportunity.

Chapter 7: Setting the Rates

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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.