Public Spending, Pay And Pensions

9th October 2022

A report by the Institute For Fiscal Studies.

Key findings
1. The public sector pay settlements announced this July will pose severe budgetary challenges for many areas of government. Overall funding for public services was fixed in cash terms for the next three years in last October's spending review, at which this year's double-digit inflation was not predicted. Departmental budgets were predicated on pay awards in the region of 3%, far below the current rate of inflation, and below the pay awards of roughly 5% (on average) announced over the summer. These pay awards are estimated to increase departmental staffing costs by around £5 billion this year, compared with the (approximate) 3% baseline built into existing spending plans. Offering an inflation-matching pay award to all public sector employees would add more like £18 billion.

2. Departmental funding settlements have not been increased to account for these additional costs. Meeting them from within existing budgets will be especially challenging given the context of sharply rising energy prices and elevated general inflation, which reduces the scope for savings elsewhere. If costs were met entirely through cuts to employment (i.e. to keep the total wage bill to what was expected when the spending settlements were made), a reduction of approximately 110,000 public sector workers (or 1.9% of the projected 2022-23 public sector workforce) would be necessary this year. Full inflation protection for public sector employees would increase that number to 390,000 (or 6.8% of the workforce). If some areas of government (e.g. the NHS) were exempt from any headcount cuts, the required cuts elsewhere would be deeper.

3. The challenge is, if anything, more acute in future years. Compensating departments for the additional costs of the pay awards this summer would mean an additional £5 billion or so this year (2022−23); if pay awards matched inflation after this year, that figure would rise to more than £10 billion by 2024−25. If no such compensation were forthcoming, the government would have to cut headcount by more than 220,000 by 2024−25 (or 3.8% of the projected 2024-25 public sector workforce) to stay within existing plans for the staff pay bill. If, instead, the government offered inflation-matching pay awards this year and each of the next two years, the additional costs would rise to around £25 billion by 2024−25, or the headcount reduction required to stay within existing budgets to 500,000 (8.6% of the public sector workforce).

4. The new Chancellor Kwasi Kwarteng must either top up those spending plans to fund these higher-than-expected pay awards or accept that the quality of public services will (further) deteriorate. This is one of the central fiscal choices for this autumn. Indeed, this could be among the defining decisions of the remainder of this parliament.

5. There is a case for reforming the fiscal framework to lessen the disconnect between the planning horizons for public sector pay (set annually) and departmental budgets (set on a multi-year basis). That could be achieved by setting the same planning horizons for both; longer-term horizons, though, would exacerbate pre-existing problems of public sector pay inflexibility, and shorter-term horizons might impede departments' ability to budget effectively. Our preference would be to instead reform the spending framework, so that settlements are automatically reopened and reassessed in exceptional circumstances, defined as occurring when pay and/or other cost increases deviate sufficiently from the assumptions made (and published) when plans were originally set.

6. Even the higher-than-budgeted pay awards this year may not be enough to head off concerns around recruitment and retention - or widespread industrial action. The vast majority of public sector workers will experience a real-terms pay cut this year, and are likely to experience a bigger real-terms cut than their counterparts in the private sector. Public sector pay awards of 4-5% this year imply real-terms cuts of more than 5%, and are broadly similar to expected private sector pay settlements of around 6% (though may compare less favourably when bonuses, more widespread in the private sector, are taken into account).

7. The gap between pay growth in the two sectors this year is unlikely to be especially large, but comes after a decade in which public sector pay has been falling relative to the private sector and, for many public sector jobs, falling in real terms. The government needs to ensure it has the right number and mix of staff to provide its desired range and quality of public services. It is therefore essential to consider trends in public and private sector pay (and overall remuneration) together: the private sector helps define outside options for public sector workers. The continuing fall in public sector pay relative to the private sector poses recruitment and retention challenges for public services, and could threaten the government's ability to deliver on its public service objectives (such as clearing the NHS backlog, ‘levelling up' primary education and reforming adult social care funding).

8. The raw difference between public and private sector hourly pay levels, which does not take account of the different characteristics of employees in the two sectors, has fallen from 13% in 2007−08 to 7% in 2021−22. The conditional public-private pay differential, which controls for the fact that public sector workers tend to be more educated, older and more experienced, has fallen steadily from around 3% in 2007−08 to slightly below zero in 2021−22. This public-private pay differential is now less favourable to the public sector than at any point in the past 30 years. This is true of both men and women, though the estimated public-private pay differential for women in 2021−22 remains positive (+2.2%) and considerably higher than for men (−4.6%).

9. Alongside pay, employer contributions to pension schemes are an important part of the overall difference between public and private sector remuneration. Public sector workers are much more likely to be enrolled in a workplace pension (91% had a workplace pension in April 2021, compared with 75% of private sector employees) and more likely to be in – typically much more generous – defined benefit schemes (82% were in a defined benefit scheme in 2021, compared with 7% of private sector workers). Whereas almost half (47%) of public sector employees received an employer pension contribution of at least 20% of their pay in 2021, the same was true of just 2% of private sector employees.

10. The relative generosity of employer pension contributions in the public sector has been growing over time. The average employer contribution rate in the public sector grew by around 5 percentage points between 2012 and 2021, rising to 18% of pay in 2021. The average employer contribution rate in the private sector is considerably lower and has been growing more slowly: the average across all private sector employees (including those who do not participate in a pension scheme) rose by around 2 percentage points over the same period, reaching almost 6% of pay in 2021.

11. When taking an estimate of employer pension contributions into account, there was a raw difference of 21% between average public and private sector remuneration in 2021. When controlling for employee characteristics, we estimate the average public–private remuneration differential to be around 6% (meaning that public sector workers are paid roughly 6% more than their private sector counterparts on average, once pensions are accounted for). This total remuneration differential has fallen in recent years, but to a lesser extent than when considering pay alone, as a result of the increasing relative generosity of public sector pension contributions.

12. There is a strong case for rebalancing public sector remuneration away from pensions and towards pay. A far greater share of overall public sector remuneration is deferred, in the form of both employer and employee pension contributions, compared with the private sector (20.1% versus 7.6% on average in 2021), and this difference has been increasing over time. That means for a given level of remuneration, take-home pay is lower in the public sector. One option, as a starting point, would be to reduce employee pension contributions in the public sector, alongside a commensurate decrease in pension generosity. That would increase take-home pay for public sector employees with no change to the costs for their employers.

13. The public sector pay differential varies considerably across the UK, implying that regions may face varying levels of difficulty with recruitment and retention, and potentially creating unintended and undesirable variation in the quality of public services. The conditional public–private pay (and total remuneration) differential is lowest in London and the South East, and highest in Wales, Scotland and the North East. The average nurse in the North East earns 17% more than the average employee in the region, versus just 5% more in the East of England and 9% less in London. The average secondary school teacher in the North East or Wales earns over 50% more than the average in their region; a secondary school teacher in the South East earns 22% more than the average. Pay is not, of course, the only factor affecting the public sector's ability to recruit and retain skilled workers, and it is not obvious that the areas with the lowest public–private differential are those facing the greatest difficulties with recruitment.

Read the full report HERE
55 pages can be read on the web page or download as a Pdf