The wages of public sector workers should grow at the same pace as private sector wages, according to research by Pedro Gomes, published in the September 2015 Economic Journal.
His study shows how over the business cycle, the ideal government policy consists of ''pro-cyclical'' public sector pay. If wages in the public sector do not respond to the cycle, recessions make them more attractive relative to wages in the private sector, inducing more unemployed people to queue for public sector jobs. This further dampens job creation in the private sector and amplifies the business cycle. If public sector wages do not respond to the cycle, unemployment volatility increases substantially.
The research examines ''optimal'' public sector wage policy using an approach to analysing the labour market pioneered by Nobel laureate Christopher Pissarides. The key mechanism builds on the observation that unemployed people direct their search to the public or private sector, depending on the wages and probabilities of finding a job (and of losing it once found).
Because the unemployed have a choice of where to search, public sector wages have a crucial role. If the government sets a high wage, for example, due to strong public sector unions, it induces too many unemployed people to queue for public sector jobs and raises private sector wages, thus reducing private sector job creation and increasing unemployment.
Conversely, if the government sets a low wage, for example, due to budgetary constraints, few unemployed people want a public sector job and the government faces recruitment and retention problems.
The study finds that public sector wages should be primarily linked to private sector wages, with a small adjustment factor. This ''optimal wage premium'' depends on the difference in the labour market frictions between the two sectors.
For example, safer public sector jobs induce many unemployed people to concentrate their search on this sector; thus, the government should offer lower wages to offset this. For the chosen calibration, the optimal wage is 2.5% lower than in the private sector.
These results are relevant in two ways. First, researchers estimate that the public sector wage premium, although positive on average, differs substantially across education groups and occupations. Some groups have a high premium and others have a very negative premium.
This implies that for some workers, the government faces recruitment and retention problems, while for others, the government is less willing to hire. The first result can help to guide a reform of public sector wages to homogenise relative pay across workers, improving efficiency in the sector.
Second, many countries have a discretionary approach to the determination of public sector wage growth, which makes it more vulnerable to manipulation for electoral reasons. The results of the new study provide the rationale for a fiscal rule to determine yearly public sector wage growth: the average public sector wage should follow the average private sector wage. This simple rule is followed by some countries, notably Denmark, and can improve on the discretionary approach.
Government employment is a sizeable element of the labour market and an important aspect of fiscal policy. In the UK, around 20% of all employees work in the public sector. The public sector wage bill represents more than half of government consumption expenditures. Given the proportion of this type of expenditure, it is vital for the public sector to have an efficient wage-setting process.
''Optimal Public Sector Wages'' by Pedro Gomes is published in the September 2015 issue of the Economic Journal. Pedro Gomes is at the Universidad Carlos III de Madrid.