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Ian Brinkley
Economic Advisor
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Ian Brinkley

LABOUR MARKETS, the SPENDING REVIEW, and the OBR

Authors: Ian Brinkley Senior Economic Advisor

01 December 2015

The Spending Review took place against a benign labour market background, with increasing employment, falling unemployment, strong real wage growth - but no sign of wage inflation. This is broadly speaking how the Office for Budget Responsibility (OBR) sees things carrying on over the next five years.

But they won’t. The OBR economic forecast looks more like a straight-line projection, so each year is assumed to be much like the year before. As economies hardly ever move in a straight line for very long, we can say with some certainty that the next five years will not be without its labour market ups and downs.

The OBR is assuming that unemployment has gone as low as it can over the forecast period. The unemployment rate is assumed to average 5.5 per cent in 2015 and after a brief dip is expected to be 5.4 per cent in 2020. At TWF we estimate the unemployment rate associated with full employment on an historical basis at around 4 per cent, so the Chancellor’s goal of full employment is tantalisingly close but remains elusive.
As the OBR has done its best to take into account specific policy measures, we either have to hope that the OBR has been too pessimistic; or that there will be a bigger than expected impact on the labour market of existing measures; or that new measures are introduced that would push unemployment below 5 per cent.
For many of those in work there will be good news on the wage front. The OBR thinks average wage growth will accelerate to between 3 and 4 per cent from 2016 onwards. Yet inflation is assumed to remain below 2 per cent until 2019, implying strong and sustained real wage growth.
Some will miss out – those in the private sector who earn more than the National Living Wage but who have limited bargaining power, and many public sector workers on the assumption that public sector pay policy is sustained. I suspect the pay policy will not survive in its current form to 2020 and that ways will be found to widen out the current limited flexibilities as staff shortages start to bite in ways that the voting public notice.
For those at the bottom end of the labour market even bigger rises are in store as the National Living Wage (NLW) kicks in - the OBR is projecting an increase of just under 30 per cent between 2016 and 2020 to reach the notional target of 60 per cent of median hourly wages, or well over 6 per cent per annum. Workers paid above the NLW but in the bottom quarter of the wage distribution are also assumed to get a boost, although the increase is more modest.
The OBR has retained the previous estimate of 60,000 job losses nationally for the NLW, but also thinks there could be some loss of hours worked which will reduce the gain in terms of weekly earnings. The OBR estimates that across all the groups affected the average gain will be £11 in weekly earnings, but once firm responses in terms of hours and loss of jobs is taken into account, the average gain will fall to £6 in weekly earnings.
The increase in social care funding from local taxation may take some of the pressures off the social care sector, but it is hard to see how it can both cover the cost of higher wage-bills from the NLW and improve provision. Social care still remains the sector facing the biggest challenges in coping with the NLW, as it is hard to improve productivity rapidly or to pass on cost rises to either individuals or local authorities
Employment is also bumping up against an upper limit – the total numbers in work will still go up but at a more modest pace, but the all-age employment rate (the share of the population in work) is assumed after a small temporary rise to be much the same in 2020 as it was in 2015. The Government’s ambition to have the highest employment rate (measured by the share of people of working age in a job) in the G7 looks more dependent on employment rates in other countries declining rather than the UK rate rising.
The big cuts in public sector employment seem to be at an end. The OBR projections for general government employment assume that between the current financial year 2015-2016 and 2019-2020 total employment will fall by just 40,000. This is much less than the fall over the previous five years of 530,000 or nearly 10 per cent, albeit the past fall includes large numbers of employees in further education being reclassified to the private sector.
The OBR has to make some pretty crude assumptions on future trends for wage-bills and wages per head to get these figures as it has no better data to work with, so the actual outcome could be better or worse and the timing is anyone’s guess. Moreover, some parts of the public sector will see painful reductions. For example, big planned cuts in the cost of some Whitehall Departments and further cuts in local government funding imply further job losses in the civil service and some groups of local authority workers.
But the even bigger unknown is what will happen to productivity. In some past forecasts the OBR has assumed that a productivity recovery is just round the corner, only to have its assumptions confounded. The OBR is rightly cautious about recent improvements, which it says could be explained by temporary factors and cyclical changes. It goes on to say that: “since it is difficult to explain the abrupt fall and persistent weakness of productivity in recent years, it is also hard to judge when or if productivity growth will sustainably return to its historical average”. The OBR is nonetheless projecting that there will be a gradual improvement, with pre-crash rates reached in 2018.
We also have no idea whether the NLW will induce firms in low paying sectors to improve productivity significantly and whether that gain will be big enough to impact on the aggregate figures for the economy as a whole. There are positive historical precedents from past NMW rises and some recent surveys have suggested that many employers say they will cope with it through better productivity– though sustaining big productivity gains in the short-term is not easy and what employers say in a survey may be different to what they do in practice.
Either way, let us hope that the OBR is right this time round. If we see no recovery in productivity over the next few years the outlook for growth, employment and wages could look very different and not necessarily for the better.