4 Choosing a New Rate

To inform our thinking about the future rate of the National Minimum Wage, we begin by examining the views of key stakeholders, including representatives of employers and firms affected. We then go on to assess the state of the economy, looking at such factors as the prospects for the near-term future and recent trends in employment, prices, earnings and pay settlements.

Having arrived at our recommendation, we then assess the impact it is likely to have. We consider the future coverage, the effect on the wage bill, at both the aggregate and the sectoral levels, and the impact on prices and on public sector finances.

Stakeholders’ Views

We received a wide range of evidence from employers and unions on uprating the minimum wage. Nearly all interested parties accepted the case for uprating. Many firms and their representatives acknowledged that across the country wages have been driven up by recruitment difficulties in tight labour markets and that the additional impact of the minimum wage had been small.

But, as discussed in Chapter 3, much of the evidence emphasised that there were still some areas where significant numbers of employees were paid the National Minimum Wage. The Association of Convenience Stores told us that convenience stores ‘employ staff at close to the National Minimum Wage rate — especially in rural and remote areas. Any further increase in the National Minimum Wage rate would lead to additional costs for these businesses, and also for retailers whose staff wish to maintain their differential above lower-paid staff in all sectors’. Results from a survey of their members showed that around a quarter had altered their lowest rates of pay to be at or above the level of the minimum wage.

A significant number of businesses were comfortable with an adult rate of around £4 per hour. The British Security Industry Association wrote in its evidence that among its members ‘the consensus is that the wage rate should be even higher at £4 per hour’. The British Hospitality Association was more cautious: ‘it seems a reasonable assumption that an increase in the NMW to a figure above £4 would add considerably to payroll costs of hospitality employers in those regions and sub-regions where pay is lower because of market conditions’. The CBI expressed concern about a minimum wage significantly above £4 per hour. In oral evidence the CBI emphasised that the business climate was now more difficult than when the minimum wage was introduced, with more company mobility globally, slowing consumer growth and fiercer competition.

Some businesses were concerned even about a figure below £4 per hour. The Hairdressing Employers Association and the National Hairdressers’ Federation suggested that ‘a Basic Rate in excess of £3.85 an hour would start to place pressure on employment numbers’. The Cleaning and Support Services Association said that ‘the majority of members are in favour of an increase in the NMW in 2001, but it should be restricted to 10p per hour, or not higher than the RPI’. Similarly, the British Apparel and Textile Confederation argued that any increase in the minimum wage should be kept to the minimum and no more than the level of inflation as measured by RPIX.

The Federation of Small Businesses (FSB) asked that — at this stage — the possibility of increasing the National Minimum Wage be approached with caution. In their evidence to us, they reported that results of a survey of FSB members revealed that the average wage paid by members to their lowest-paid staff was far above current minimum wage levels. The FSB stated that it was ‘not aware of any broad negative effects the introduction of the National Minimum Wage may have had on the competitiveness of small firms’. But it also believed that ‘any further increases to the minimum wage in the near future could contribute to endangering the existence of some smaller businesses or at least to reducing their capacity to increase or maintain their current workforce’.

Evidence we received from employee representatives generally argued in favour of a more substantial increase. They pointed to the strong economic conditions, buoyant earnings growth and lack of adverse employment effects as evidence that a significantly higher rate could be sustained without damaging the economy.

Several bodies were concerned about the low coverage of the minimum wage and the fall in its real value since it was introduced. UNISON explained in its evidence that it favoured an immediate higher level of the adult rate set at £5 per hour. It argued that the initial rate had been set too low and that as a result too few people had benefited from the minimum wage. This, together with buoyant average earnings and economic growth, meant that its real value had declined since our initial recommendation. The Yorkshire and Humberside Low Pay Unit also presented evidence along these lines, arguing that the National Minimum Wage should, as a minimum first step, be increased sufficiently to restore the real value it had when it was first introduced. The Unit said that it could understand the reasons behind the prudent approach that we took in setting the initial rate, but argued that not increasing the minimum wage until 18 months after introduction and by less than both retail price and wage inflation had reduced its real value and its credibility as a component of the strategy to reduce poverty.

The approach adopted by some, for example UNISON and the Low Pay Unit, was in favour of the minimum wage being set at half male median earnings. They maintained that this was justified on the grounds of fairness and equity. Using such a measure would ensure that the relative position of the minimum wage in the earnings distribution remained constant over time, and that the low paid would share in the increased prosperity of the country. The Low Pay Unit argued for regular upratings since their research showed that many of the workers interviewed had never had a pay rise.

In its oral evidence, the TUC referred to the benefits which employers had gained from the minimum wage. And in its written evidence, it argued that in the hospitality sector ‘low pay is clearly a barrier to developing a skilled, high-productivity workforce’. It suggested that a large increase in the minimum wage could ease recruitment difficulties in that sector and might be expected to trigger efficiency effects.

Much of the evidence presented to us referred to the favourable economic conditions in which the minimum wage was introduced. Particular attention was paid to the strong growth in earnings since April 1999, leading to a fall in the real value of the minimum wage. The next section of this chapter reviews future economic prospects and analyses recent trends in employment, prices, earnings and pay settlements.

The Economy

We examined the latest predictions about prospects for growth and risks to the economy in the medium term. The Bank of England Inflation Report (February 2001) states that the central projection for annual GDP growth is expected to dip to around 2 per cent in the latter half of 2001, before returning to around the supply capacity of the economy in 2002. The HM Treasury Pre-Budget Report (November 2000) predicts growth at between 2.25 and 2.75 per cent in the short to medium term. Meanwhile, the Bank’s central projection for underlying inflation is that it will stay at around 2 per cent throughout 2001 before picking up the following year, while the Treasury forecasts a slightly higher rate. Both forecasts assume constant nominal interest rates. We noted that the consensus of independent forecasters was for a modest slowdown in growth coupled with stable inflation (Bank of England Inflation Report, February 2001).

In recommending a new rate, we were conscious that we should not damage the employment prospects of those the minimum wage is intended to benefit. We commissioned a study (Stewart, 2001) of the effects of the introduction of the minimum wage on employment in the UK. The results of this were discussed in detail in Chapter 3, and they pointed to a broadly neutral effect on employment.

The UK study was based on data up to Autumn 1999. Hence it can show only the initial impact on employment. Since employment effects may take time to feed through into the labour market, we also reviewed the latest research from other countries where a minimum wage had been in operation for some time. In addition, we gathered evidence from employers about the likely employment impact of future upratings.

In our first report we reviewed the extensive literature on the effect of minimum wages on employment. The OECD Employment Outlook (1998) also published a summary of studies from different countries, using a variety of modelling techniques. These often produce conflicting evidence on the effect of minimum wages on job losses. Orthodox theory predicts that a minimum wage set above market rates leads to job losses, but the new economics of the minimum wage argues that this is not always the case (see, for example, Card and Kreuger, 1995). Explanations for the lack of a negative employment effect centre on the existence of imperfections in the labour market which cause employees to be paid less than the value of the work they produce. This might occur, for example, where there is imperfect information and employees are not fully aware of all jobs available to them; where there are large search costs involved in looking for another job; or where employees’ bargaining position is limited.

There is evidence of imperfect information in some labour markets. When we met homeworkers, for example, we found that their bargaining position was constrained because they were fragmented geographically and they had very little awareness of other homeworkers doing similar work. This meant they faced barriers in attempting to organise themselves into effective bargaining units.

Many recent studies (eg Neumark, 1999; Bazen and Marimoutou, 2000; and Turner and Demiralp, 2000) have tapped into new data sources and methodological approaches. These have produced contradictory evidence as to the direction and size of the employment effect arising from the introduction of a minimum wage. While not conclusively supporting a positive employment response, these studies suggest overall that any negative effects are small and tend to be confined to the most disadvantaged groups in the labour market such as youth, certain ethnic minority groups and the least skilled.

Evidence from the UK does not so far suggest that vulnerable groups have experienced negative employment effects. Employment across most age groups and ethnic minorities has increased since the introduction of the minimum wage. Our commissioned research (Stewart, 2001) showed that young men and women experienced zero or, if anything, mildly positive effects. We therefore conclude that in the medium term the employment effects, whether positive or negative, are likely to be small at the rate we are recommending.

As well as future growth and inflation and the effect on employment, we considered recent trends in prices and earnings as a guide to future levels of the minimum wage. Measures of inflation are concerned with the increase in the cost of living. A minimum wage that increases in line with price movements will maintain its real purchasing power. As increases in money earnings generally outstrip price movements, a minimum wage that increases only in line with prices will lose its relative value as a wage floor.

We looked at recent trends in both the all-items Retail Prices Index (RPI) and RPI excluding mortgage interest payments (RPIX). A weakness of the RPI in the context of the minimum wage is that it reflects the cost of living of the average household rather than that of low-paid households. The majority of long-term pay agreements that are inflation-linked employ the RPI. In their evidence, some employers who suggested that the minimum wage be uprated in line with the RPI also suggested that the increase be capped, for example at 5 per cent.

Recent trends in prices as measured by these indices are shown in Figure 4.1 below. Following the economic downturn, inflation fell rapidly in the early 1990s and has been relatively stable over the past five or six years. Over the last two years, underlying inflation, as measured by RPIX, has been below the Government’s target of 2.5 per cent. The relationship between these two measures of inflation depends on the path of interest rates. Between mid-1997 and the latter part of 1998, RPI was above RPIX. This was due largely to tight monetary policy, which was gradually relaxed towards the end of 1998. In April 1998 mortgage interest tax relief was reduced from 15 per cent to 10 per cent, causing a temporary rise in the RPI in that year.

Figure 4.1

Retail Price Growth, 1990—2001

Source: Retail Prices Index, ONS, 1990—2001

In January 2001 RPI inflation was 2.7 per cent, with underlying inflation lower at 1.8 per cent. If the level of the minimum wage at April 1999 (£3.60) had been uprated in line with prices since its introduction, and if the latest price indicators (averaging the last three months’ data) continued in the future, we estimate that the value of the National Minimum Wage would be around £3.85 per hour in October 2001 if uprated by RPI, and around £3.75 per hour if uprated by RPIX.

Increasing the minimum wage in line with earnings would ensure that it reflected growing prosperity within the economy as a whole. The earnings indices we considered included the Average Earnings Index (AEI), earnings indicators from the New Earnings Survey (NES) and the level of pay settlements. The AEI measures changes in gross earnings based on survey returns from around 8,000 employers. Each employer includes information on the total pay bill and the number of people covered by it, with no distinction for full-time or part-time staff. Because the definition of earnings includes overtime, shift payments, bonuses and profit-related pay, in addition to basic pay, it does not correspond exactly with the definition used for the minimum wage. The AEI headline rate measures the change in the seasonally-adjusted index for the last three months compared with the same period a year earlier.

The NES, carried out in April each year, produces results from a 1 per cent sample of employees (about 150,000 people). An advantage of the NES over the AEI is that it can be used to measure increases in basic pay excluding overtime, and it therefore corresponds more closely to the minimum wage definition of earnings. Another advantage is that it can be used to estimate increases in earnings at particular points in the earnings distribution, for example, the lowest decile or the median. This means that we can identify increases for those groups that are most relevant to us, the low paid. The NES, however, has two disadvantages: it undersamples the low paid (see Appendix 1 for more details), and, because it is a ‘snapshot’ survey of one week in April, it is not sensitive to cycles in pay settlements.

Aggregate wage indices, such as the AEI and NES, do not just measure changes in pay. They may also reflect changes in the composition of the labour force and in the hours being worked in the economy. If, for example, participation drops, and those predominantly moving out of the labour force are the low paid, then increases in average earnings over time will be a product of the changed sample as well as increases in wages. The AEI can also be distorted by bonus payments, particularly at certain times of the year (eg the end of the financial year when many bonuses are paid).

The trend in median earnings from the NES has generally matched the AEI series quite closely, except for the last few years when the AEI has been higher. Since 1997 NES lowest-decile earnings have outstripped growth in the median, except for 1999 when lowest-decile earnings were just marginally lower. Latest data for April 2000 indicate that lowest-decile earnings grew at twice the median, an effect at least partly attributable to the National Minimum Wage.

If the minimum wage had been uprated by the AEI actual index since its introduction in April 1999 (£3.60), and assuming that the most recent trends (averaging the last three months’ data) continue, then its value at October 2001 would be around £3.90 per hour, slightly below the value (around £4.00 per hour) it would be if the AEI headline rate were used.

Some groups have argued that the appropriate level of the National Minimum Wage is the value equivalent to half male median earnings. Using male earnings, excluding overtime in calculating both earnings and hours — the closest definition of earnings as defined by the minimum wage legislation — we estimate half male median earnings to be £4.13 per hour in April 2000, up from £3.97 per hour in April 1999.

Figure 4.3

The IDS Pay Settlement Charts from January 1999 to December 2000 show the central range of pay increases at between 2 and 5 per cent in 1999, falling to between 2 and 4 per cent in early 2000, but rising slightly in the latter half of the year, reflecting the earlier rise in inflation. The latest IDS Pay Settlement Chart (IDS, 2001b), which includes 46 pay awards due for implementation from January to March 2001, suggests that the range of pay increases edged up slightly. Settlements due in January 2001 were bunching between 3 and 4.5 per cent. Of the 113 new awards added to the chart in January 2001, a third were worth 4 per cent or more and half were between 3 and 3.9 per cent.

Pay settlement data indicate no significant upward pressure on pay levels in 2000 but early indications are that there may have been some slight upward movement since the beginning of 2001. Most settlements have implementation dates in January, April, June or July, so awards in the latter part of the year are less significant.

Overall, the data on prices and pay show that earnings, both in terms of average earnings increases and in terms of the level of pay settlements, have increased faster than prices over the last two years. Up to April 2000, earnings at the lower end of the distribution have included increases resulting from the introduction of the minimum wage and have therefore outstripped the growth in median earnings. Since its introduction in April 1999 the level of the minimum wage has increased broadly in line with prices, lagging behind increases in earnings. This has resulted in a fall in the numbers covered by the minimum wage, as low earners have seen their wages increase above minimum wage levels.

The Rate

The minimum wage has not had an adverse impact on the economy in terms of growth, inflation or employment, due to a combination of the cautious introductory rate and favourable economic conditions. Economic growth seems set to continue, while inflation remains at a manageable level. At the same time, the labour market has been operating more efficiently and there have been underlying improvements in labour productivity. There has been continuing downward pressure on prices with underlying inflation being below the government target for the last two years. And pay settlement data indicate no significant upward pressure on pay levels.

Revisions to the estimates of numbers in low pay, and increases in the earnings of the low paid outstripping the rate of increase in the minimum wage, have led to a reduction in the numbers covered by the minimum wage since its introduction. In terms of the aggregate economy, therefore, there is scope for a substantial increase in the minimum wage.

As well as recommending a rate for 2001, we believe that the minimum wage should continue to be uprated regularly. Business has also told us that it would welcome a degree of certainty to plan for the future. Setting the right rate further into the future is more difficult as economic conditions change. We therefore recommend a small further increase in 2002, before the level of the minimum wage is reviewed again fully.

We recommend that the main National Minimum Wage for adults aged 21 and over should be increased to £4.10 per hour in October 2001 and to £4.20 per hour in October 2002.

In unanimously choosing a rate to recommend to the Government, we wanted to satisfy ourselves of the likely impact. We wanted the rate we recommended to make a difference to those on low pay, but we also had to be sure that it could be accommodated by the economy and by business. A rate that was not manageable would hurt the prospects of  the very people it was meant to protect by damaging employment, profitability and competitiveness. We are also well aware that the impact of the minimum wage will vary greatly across sectors and across different sizes of business.

We explained in Chapter 3 that our assessment of the coverage of the minimum wage is complicated by problems with estimates made from official data sources. In our first report we estimated that 8.5 per cent of jobs for those aged 21 and over would be covered by our recommendations. Under the refined ONS methodology this proportion fell to around 5.4 per cent. In setting a rate for 2001 we took account of the implications of these new estimates of numbers in low pay and their implications for the coverage of the minimum wage.

These are broad-brush assumptions. In the last few years it has been difficult to disentangle underlying increases in wages of the low paid from increases at the bottom end of the earnings distribution arising from action in anticipation of the minimum wage. In our two previous reports we therefore used forecast inflation to estimate the real value of the minimum wage. In this report, however, we have used average earnings as they are a more appropriate measure for downrating to real values and the minimum wage effect will have less impact now on the earnings series than was present at the time of the introduction of the minimum wage.

If the earnings of the low paid rise by less than our prediction of the increase in average earnings, this method will lead to an understatement of the number of jobs covered by the new level of the minimum wage. There is evidence from low-paying sectors that earnings have been rising by less than average; for example, the British Retail Consortium noted that earnings in the retail sector have fallen behind average earnings.

Assuming that earnings of the low paid increase in line with average earnings, we estimate the real value of a £4.10 per hour minimum wage in October 2001 to be around £3.85 per hour at April 2000 levels. The number of jobs of those aged 21 and over below this level is in the region of 1.3 million, around 5.5 per cent of jobs. If we assumed a smaller percentage increase in earnings of the low paid, say in line with prices, then the real value of the minimum wage would be higher, around £3.95 per hour at April 2000. This would represent around 1.5 million jobs, or around 6.6 per cent of those aged 21 and over.

We were told that the minimum wage received wide acceptance from businesses because it was set at a rate that was sustainable for them. A higher rate may have had serious adverse consequences on employment and compliance. We considered these arguments alongside evidence we received from businesses on affordability and from research on employment effects. We looked at the impact of our recommendation on the aggregate economy as well as on vulnerable sectors and regions.

In order to test the sensitivity of our assumptions on the aggregate wage bill, and because identifying precise break points in our data is subjective, we adopted two assumptions on the degree of wage restoration. The first is that wage restoration would be limited to around the eighth percentile (D1), the second is that there would be a continued, but lower, effect up to around the fortieth percentile (D2).

There are several reasons why these estimates could be overstating the wage bill effect. We have assumed that compliance is universal, and although we have not seen evidence of large-scale non-compliance, it would be fair to assume that it was less than 100 per cent. Second, we established a baseline for October 2001 that assumed increases in wages up to the new minimum, but no restoration of differentials. Because earnings of the low paid are likely to have increased faster than the increase in the minimum wage, this will understate the baseline wage bill and hence overstate the impact of the new rates. We also found that some employers had reduced hours; this will reduce the estimates further. We have therefore placed more weight on the lower bound estimates.

These findings are consistent with findings from our survey of low-paying sectors of the initial impact of the introduction of the minimum wage. This shows that hairdressers were most likely to report a significant increase in the wage bill resulting from the introduction of the minimum wage. Our new estimates suggest that this would continue to be the case as the minimum wage is uprated. The impact of the uprating, however, would not be as great as that of the initial introduction.

The assumptions on differentials make less difference to the low-paid sectors than they do on aggregate. For example, in the hairdressing sector, the effect of including the larger differentials assumption in the wage bill estimate (D2) increases the impact on the wage bill from 1.8 to 2.2 per cent, an increase of 20 per cent. This compares with a more than doubling of the wage bill impact for the economy as a whole when D2 is included in the calculation. This is because the low-paying sectors have proportionately fewer workers higher up the earnings distribution where these assumptions bite.

We saw in Chapter 3 that the minimum wage had no discernible impact on the main measures of inflation, or on components within the RPI that were particularly associated with low-paying sectors. There was some evidence, from individual firms and sectors, that the minimum wage had caused them to raise prices for certain goods and services. In practice, the extent to which this happened depended on a number of factors. These included the increase in the wage bill faced by individual firms, conditions in labour and product markets, and the way in which firms and individuals responded to the new rate, particularly in making productivity and efficiency changes.

We noted in Chapter 3 that firms exhibited a range of responses to the minimum wage. One of the important findings from our research and consultation was that firms that were restricted in raising prices (for example, because they faced strong international competition) were more likely to make other adjustments to contain costs such as reducing hours or employment. As the minimum wage is increased, such adjustments may become more widespread.

Judgments about the impact of our recommendation on inflation cannot be made in isolation from the macroeconomic response by the Bank of England. The Monetary Policy Committee has a target for underlying inflation as measured by RPIX of 2.5 per cent. In the Bank of England’s Inflation Report (February 2001), the central projection for underlying inflation throughout 2001 is around 2 per cent, before starting to pick up to reach its target the following year. The report notes that inflationary pressures have weakened recently, reflecting the impact of lower growth and energy prices. Some forecasters put more weight on supply-side improvements and on the United States’ slowdown mentioned in paragraph 4.19. These might be expected to lower the inflation profile by up to 0.5 per cent. Although there are risks with any forecast, the projections suggest continuing low and stable inflation.

Another key assumption underlying these simulations is that there is no dynamic response on the part of individuals or firms. The models do not take account of adjustments that we have seen firms make, for example, in controlling labour costs. They are thus likely to be an upper bound. In addition, the models take no account of the potential gains to labour productivity, which will reduce unit wage costs and hence reduce pressure on inflation. If firms in the sectors most affected by the minimum wage continue to respond positively in making productivity gains, while competitive pressures limit the extent to which they increase prices, then we might expect the inflationary impact of the new rate to be subdued. Because we have not linked our recommended increase to a specific uprating index, and have taken into account views from firms on what they can afford, we would not expect any subsequent price increases to have a lasting effect on inflationary expectations.

Models of the inflationary response do not take account of the impact of the change in government expenditure. In assessing the impact of the future rate on public sector finances, we looked at its impact on the size of the public sector wage bill; expenditure on tax credits and benefits; tax and National Insurance receipts; and the costs of goods and services procured from the private sector.

These estimates take no account of any secondary behavioural impact of the minimum wage, in particular of increases in spending on out-of-work benefits resulting from any adverse employment effects. We have not attempted to forecast this as, to date, we have no evidence that points to significant increases in unemployment resulting from the introduction of the minimum wage. Advice from the Government is that the calculations of the impact of the minimum wage on income tax, corporation tax and National Insurance are too approximate to enable them to break the figures down further, or to provide additional estimates to those given in the Government’s evidence (December 2000).

Conclusion

Our decision on what to recommend is based on analysing a wide range of evidence from, among others, employers, trade unions and other groups representing the low paid, low-paid workers themselves, economists, commissioned research and our interpretation of official statistics. The strength of the economy and downward revisions to the numbers in low pay suggest that a substantial increase in the minimum wage is justified.